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    Fundamentals of Economics
    FOURTH EDITION

    William Boyes
    Arizona State University

    Michael Melvin
    Arizona State University

    Houghton Mifflin Company Boston New York

    To our families
    W.B.

    M.M.

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    Copyright © 2009 by Houghton Mifflin Company. All rights reserved.
    No part of this work may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or by any information storage
    or retrieval system without the prior written permission by federal copyright law. Address
    inquiries to College Permissions, Houghton Mifflin Company, 222 Berkeley Street, Boston,
    MA 02116-3764.
    Printed in the U.S.A.
    Library of Congress Catalog Number: 2007936150
    ISBN-10: 0-618-99267-7
    ISBN-13: 978-0-618-99267-6
    1 2 3 4 5 6 7 8 9–CRK–11 10 09 08 07

    Brief Contents

    PA R T O N E
    1

    The Price System
    Economics and the World Around You

    2
    4

    Appendix to Chapter 1: Working with Graphs

    18

    2

    Markets and the Market Process

    26

    3

    Applications of Demand and Supply

    52

    PA R T T WO

    Consumers, Firms, and Social Issues

    80

    4

    The Firm and the Consumer

    82

    5

    Costs and Profit Maximization

    98

    6

    Competition

    114

    7

    Business, Society, and the Government

    132

    8

    Social Issues

    156

    PA R T T H R E E
    9

    The National and Global Economies

    184

    An Overview of the National and International Economies

    186

    10

    Macroeconomic Measures

    204

    11

    Unemployment, Inflation, and Business Cycles

    228

    12

    Macroeconomic Equilibrium: Aggregate Demand and Supply

    252

    13

    Fiscal Policy

    280

    14

    Money and Banking

    300

    PA R T F O U R

    Macroeconomic Policy

    322

    15

    Monetary Policy

    324

    16

    Macroeconomic Policy, Business Cycles, and Growth

    354

    17

    Issues in International Trade and Finance

    378

    18

    Globalization

    400

    iii

    This page intentionally left blank

    Contents
    Preface

    xi

    PART ONE

    CHAPTER 1

    The Price System

    2

    Economics and the World Around You

    4

    Preview

    4

    1. The Definition of Economics
    1.a Scarcity and Opportunity Costs

    7
    7

    Summary / Exercises / Internet Exercise

    14

    Global Business Insight: “Free” Air?

    7

    Study Guide

    15

    1.b Resources and Income

    8

    2. Specialization and Exchange
    2.a Benefits of Trade

    11
    11

    A P P E N D I X TO C H A P T E R 1

    Working with Graphs

    1. Reading and Constructing Graphs
    1.a Constructing a Graph from a Table
    1.b Interpreting Points on a Graph
    1.c Shifts of Curves

    18
    18
    19
    20

    2. Application: The PPC
    2.a Interpreting Graphs: Points Inside
    the Production Possibilities Curve

    21

    CHAPTER 2

    2.b Specialization and Comparative Advantage
    2.c Gains from Trade

    2.b Interpreting Graphs: Points Outside the
    Production Possibilities Curve
    2.c Shifts of the Production Possibilities Curve
    2.d Gains from Trade
    Summary / Exercises

    12
    12

    18
    22
    22
    24
    25

    22

    Markets and the Market Process

    Preview

    26

    1. Allocation Mechanisms
    1.a Efficiency
    1.b Alternatives to Market Allocation

    28
    29
    31

    2. How Markets Function

    31

    3. Demand
    3.a The Law of Demand
    3.b The Demand Schedule
    3.c The Demand Curve
    3.d From Individual Demand Curves to a
    Market Curve
    3.e Changes in Demand and Changes in
    Quantity Demanded

    33
    33
    34
    34

    4. Supply
    4.a The Law of Supply
    4.b The Supply Schedule and Supply Curve

    38
    38
    38

    35
    35

    26
    4.c From Individual Supply Curves to the
    Market Supply
    4.d Changes in Supply and Changes in
    Quantity Supplied

    5. Equilibrium: Putting Demand and
    Supply Together
    5.a Determination of Equilibrium
    5.b Changes in the Equilibrium Price:
    Demand Shifts
    5.c Changes in the Equilibrium Price:
    Supply Shifts

    38
    39
    41
    41
    42
    44

    Summary / Exercises / Internet Exercise

    45

    Study Guide

    48

    v

    Fundamentals of Economics
    FOURTH EDITION

    William Boyes
    Arizona State University

    Michael Melvin
    Arizona State University

    Houghton Mifflin Company Boston New York

    CHAPTER 3

    Applications of Demand and Supply

    Preview

    52

    1. The Market for Low-Carb Foods

    53

    2. The Labor Market

    56

    Global Economic Insight: Jobs Moving Offshore

    56

    2.a Illegal Immigration
    2.b Immigration Policy
    3. Examples of Market Restrictions
    3.a The Market for Medical Care
    3.b The Market for Human Organs

    PART TWO

    CHAPTER 4

    60
    62
    64
    64
    66

    1. Revenue
    1.a Total, Average, and Marginal Revenue

    82
    82

    2. How Does a Firm Learn About Its Demand?
    2.a Example: Demand for Auto Safety
    2.b Example: Demand for Oranges
    2.c Example: Location

    84
    85
    85
    85

    3. Knowing the Customer
    3.a The Price Elasticity of Demand

    85
    86

    98

    1. Costs
    1.a Total, Average, and Marginal Costs
    1.b Why Are the Cost Curves U-Shaped?

    98
    98
    100

    2. Maximizing Profit
    2.a Economic Profit

    102
    103

    77

    80
    82

    3.b Price Elasticity and Revenue
    3.c Determinants of Price Elasticity

    88
    89

    Global Business Insight: Price Adjusting
    Vending Machines

    89

    4. What’s to Come?

    91

    Summary / Exercises / Internet Exercise

    91

    Study Guide

    93

    98
    3. The Profit-Maximizing Rule: MR  MC
    3.a Graphical Derivation of the MR  MC Rule
    3.b What Have We Learned?

    104
    104
    107

    Summary / Exercises / Internet Exercise

    108

    Study Guide

    110

    114

    Preview

    114

    1. Competition and Entry
    1.a Commodities and Differentiation

    114
    114

    1.b Monopoly
    1.c Competition and the Shape of Demand
    Curves

    vi

    74

    Competition

    Economic Insight: The American Girls
    Phenomenon

    69
    70
    71
    72

    Study Guide

    Costs and Profit Maximization

    Preview

    68

    Summary / Exercises / Internet Exercise

    The Firm and the Consumer
    82

    CHAPTER 6

    3.c Price Ceilings: The Market for Rental Housing
    3.d Price Floors: The Market for Agricultural
    Products
    3.e Tariffs
    3.f Quotas
    3.g Bans: The Ban on Trans Fats

    Consumers, Firms, and Social Issues

    Preview

    CHAPTER 5

    52

    115
    116
    117

    2. Creating Barriers to Entry
    2.a Brand Names
    2.b Firm Size and Economies of Scale

    119
    119
    121

    3. The Benefits of Competition
    3.a Consumer Surplus
    3.b Creating Destruction

    122
    123
    124

    Summary / Exercises / Internet Exercise

    126

    Study Guide

    128

    Contents

    CHAPTER 7

    Business, Society, and the Government

    Preview

    132

    1. Alternatives to the Market
    1.a Disagreement with the Market Outcome
    1.b Cartels, Collusion, and Monopolization

    132
    133
    133

    Global Business Insight: Dumping

    134

    Economic Insight: eBay and Online Markets

    136

    1.c Antitrust
    1.d Economic Regulation
    2. Market Failures
    2.a Externalities

    CHAPTER 8

    136
    138

    142
    142
    143
    143

    Summary / Exercises / Internet Exercise

    149

    Study Guide

    151

    139
    139

    Social Issues

    156

    Preview

    156

    1. Global Warming
    1.a The Market for Natural Resources
    1.b Environmental Problems
    1.c Solving Global Warming

    156
    156
    158
    161

    2. Illicit Drugs
    2.a The Suppliers
    2.b The War on Drugs
    2.c Alternative Drug Policies

    163
    163
    165
    167

    3. Discrimination
    3.a The Market

    167
    168

    PART THREE

    CHAPTER 9

    2.b Common Ownership
    2.c Some Goods Don’t Fit the Market:
    Public Goods
    2.d What We Don’t Know Can Hurt Us:
    Asymmetric Information
    2.e Market Problems and the Government

    132

    3.b Statistical Discrimination

    169

    Economic Insight: Discrimination and Poor
    Word-Processing Skills

    169

    4. Minimum Wage

    170

    5. Income Inequality and Poverty
    5.a Poverty
    5.b Income Distribution over Time

    171
    173
    174

    Economic Insight: The Official Poverty Rate

    176

    Summary / Exercises / Internet Exercise

    176

    Study Guide

    179

    The National and Global Economies

    An Overview of the National and International Economies

    184
    186

    Preview

    186

    3.b International Sector Spending

    191

    1. Households
    1.a Number of Households and Household
    Income
    1.b Household Spending

    186

    4. Overview of the U.S. Government
    4.a Government Policy
    4.b Government Spending

    191
    191
    193

    2. Business Firms
    2.a Forms of Business Organizations
    2.b Business Statistics
    2.c Firms Around the World
    2.d Business Spending

    188
    188
    188
    189
    189

    5. Linking the Sectors
    5.a The Private Sector
    5.b The Public Sector

    196
    196
    199

    Summary / Exercises / Internet Exercise

    199

    Study Guide

    201

    3. The International Sector
    3.a Types of Countries

    190
    190

    CHAPTER 10

    187
    187

    Macroeconomic Measures

    Preview

    204

    1. Measures of Output and Income
    1.a Gross Domestic Product

    204
    204

    Economic Insight: The Value of Homemaker
    Services

    205

    1.b Other Measures of Output and Income

    Contents

    209

    204
    2. Nominal and Real Measures
    2.a Nominal and Real GDP
    2.b Price Indexes

    212
    212
    213

    3. Flows of Income and Expenditures

    215

    4. The Foreign Exchange Market
    4.a Exchange Rates

    216
    216

    vii

    4.b Exchange Rate Changes and
    International Trade

    217

    5. The Balance of Payments
    5.a Balance of Payments Accounts

    218
    218

    CHAPTER 11

    5.b The Current Account and the
    Financial Account

    220

    Summary / Exercises / Internet Exercise

    221

    Study Guide

    224

    Unemployment, Inflation, and Business Cycles

    228

    Preview

    228

    1. Business Cycles
    1.a Definitions
    1.b Historical Record
    1.c Indicators

    229
    229
    230
    231

    2. Unemployment
    2.a Definition and Measurement
    2.b Interpreting the Unemployment Rate

    232
    232
    233

    Economic Insight: The Underground Economy

    234

    Summary / Exercises / Internet Exercise

    247

    234
    235

    Study Guide

    249

    2.c Types of Unemployment
    2.d Costs of Unemployment

    CHAPTER 12

    2.e The Record of Unemployment

    237

    3. Inflation

    239

    Global Business Insight: High Unemployment
    in Europe

    240

    3.a
    3.b
    3.c
    3.d

    Absolute Versus Relative Price Changes
    Effects of Inflation
    Types of Inflation
    The Inflationary Record

    241
    241
    244
    245

    Macroeconomic Equilibrium: Aggregate Demand and Supply

    252

    Preview

    252

    1. Aggregate Demand, Aggregate Supply,
    and Business Cycles
    1.a Aggregate Demand and Business Cycles
    1.b Aggregate Supply and Business Cycles
    1.c A Look Ahead

    3.b Changes in Aggregate Demand: Nonprice
    Determinants

    252
    253
    254
    254

    2. Factors That Influence Aggregate Demand
    2.a Consumption
    2.b Investment
    2.c Government Spending
    2.d Net Exports
    2.e Aggregate Expenditures

    255
    255
    256
    256
    256
    256

    4. Aggregate Supply
    4.a Changes in Aggregate Quantity Supplied:
    Price-Level Effects
    4.b Short-Run Versus Long-Run Aggregate
    Supply
    4.c Changes in Aggregate Supply: Nonprice
    Determinants

    3. The Aggregate Demand Curve
    3.a Changes in Aggregate Quantity
    Demanded: Price-Level Effects

    257

    CHAPTER 13

    257

    264
    264
    266
    270

    5. Aggregate Demand and Supply Equilibrium
    5.a Short-Run Equilibrium
    5.b Long-Run Equilibrium

    271
    271
    272

    Summary / Exercises / Internet Exercise

    272

    Study Guide

    275

    280

    Preview

    280

    1. Fiscal Policy and Aggregate Demand
    1.a Shifting the Aggregate Demand Curve
    1.b Multiplier Effects
    1.c Government Spending Financed by
    Tax Increases
    1.d Government Spending Financed by
    Borrowing
    1.e Crowding Out

    281
    281
    281

    viii

    264

    Global Business Insight: OPEC and Aggregate
    Supply

    Fiscal Policy

    2. Fiscal Policy in the United States
    2.a The Budget Process
    2.b The Historical Record

    260

    282
    284
    284
    285
    285
    286

    Economic Insight: The Taxpayer’s Federal
    Government Credit Card Statement

    287

    2.c Deficits and the National Debt
    2.d Automatic Stabilizers

    289
    291

    3. Fiscal Policy in Different Countries
    3.a Government Spending
    3.b Taxation

    293
    293
    293

    Global Business Insight: Value-Added Tax

    294

    Summary / Exercises / Internet Exercise

    295

    Study Guide

    297

    Contents

    CHAPTER 14

    Money and Banking

    300

    Preview

    300

    1. What Is Money?
    1.a Functions of Money
    1.b The U.S. Money Supply
    1.c Global Money

    300
    301
    302
    304

    2. Banking
    2.a Financial Intermediaries
    2.b U.S. Banking

    306
    306
    306

    Global Business Insight: Islamic Banking

    307

    PART FOUR

    CHAPTER 15

    1. The Federal Reserve System
    1.a Structure of the Fed
    1.b Functions of the Fed

    324
    324
    326

    Economic Insight: What’s on a 20-Dollar Bill?

    327

    2. Implementing Monetary Policy
    2.a Policy Goals
    2.b Operating Procedures
    2.c Foreign Exchange Market Intervention

    328
    328
    330
    336

    315

    Study Guide

    318

    322

    3. Monetary Policy and Equilibrium Income
    3.a Money Demand
    3.b Money and Equilibrium Income

    338
    339
    343

    4. The European Central Bank
    4.a The Need for a European Central Bank
    4.b The Structure of the ECB
    4.c ECB Policy

    344
    344
    345
    346

    Summary / Exercises / Internet Exercise

    346

    Study Guide

    349

    Macroeconomic Policy, Business Cycles, and Growth

    Preview

    354

    1. The Phillips Curve
    1.a An Inflation–Unemployment Tradeoff?
    1.b Short-Run Versus Long-Run Tradeoffs

    354
    355
    355

    2. The Role of Expectations
    2.a Expected Versus Unexpected Inflation

    359
    359

    Global Business Insight: Why Wages Don’t Fall in
    Recessions

    362

    CHAPTER 17

    Summary / Exercises / Internet Exercise

    324
    324

    3. Sources of Business Cycles
    3.a The Political Business Cycle

    310
    311
    312
    313

    Monetary Policy

    2.b Forming Expectations

    308

    3. Banks and the Money Supply
    3.a Deposits and Loans
    3.b Deposit Expansion Multiplier

    Macroeconomic Policy

    Preview

    CHAPTER 16

    2.c International Banking
    2.d Informal Financial Markets in Developing
    Countries

    3.b Real Business Cycles

    354
    365

    4. The Link Between Monetary and Fiscal
    Policies

    367

    5. Economic Growth
    5.a The Determinants of Growth
    5.b Productivity

    369
    369
    371

    Summary / Exercises / Internet Exercise

    372

    Study Guide

    374

    363
    364
    364

    Issues in International Trade and Finance

    378

    Preview

    378

    Economic Insight: Smoot-Hawley Tariff

    387

    1. An Overview of World Trade
    1.a Comparative Advantage
    1.b Sources of Comparative Advantage

    378
    378
    380

    3. Exchange Rate Systems and Practices

    391

    Global Business Insight: The IMF and the World
    Bank

    394

    2. International Trade Restrictions
    2.a Arguments for Protection
    2.b Tools of Policy

    383
    384
    387

    Summary / Exercises / Internet Exercise

    395

    Study Guide

    397

    Contents

    ix

    CHAPTER 18

    Globalization

    400

    Preview

    400

    3. Globalization, Economic Growth, and Incomes

    409

    1. The Meaning of Globalization
    1.a Globalization Is Neither New nor Widespread
    1.b The Role of Technological Change
    1.c Measuring Globalization

    400
    400
    401
    402

    4. Financial Crises and Globalization
    4.a Crises of the 1990s
    4.b Exchange Rates and Financial Crises
    4.c What Caused the Crises?

    411
    411
    412
    414

    2. Globalization Controversy
    2.a Arguments Against Globalization

    405
    405

    Summary / Exercises / Internet Exercise

    416

    Study Guide

    418

    Global Business Insight: The World Trade
    Organization

    406

    2.b Arguments in Favor of Globalization
    Answers for Now You Try It

    423

    Answers for Study Guide Exercises
    Glossary
    Index

    x

    407

    427

    438

    444

    Contents

    Preface

    s the title of the first chapter in this text makes
    clear, economics can be found all around you—
    in your everyday life, in the decisions you
    make, and in the news. We invite you to join us as we
    explore the economic landscape—the concepts and
    issues that confront us on a daily basis. We will consider important questions such as:

    A





















    Why study economics? (Chapter 1)
    Why do economists like market allocation?
    (Chapter 2)
    Why do people earn different incomes, and why
    do different jobs pay different wages? (Chapter 3)
    How do firms make money? (Chapter 4)
    What are the benefits of competition? (Chapter 6)
    Why does the government intervene in the affairs
    of business? (Chapter 7)
    What are the economics of global warming?
    (Chapter 8)
    How is money traded internationally? (Chapter 10)
    What is a business cycle? (Chapter 11)
    How do banks create money? (Chapter 14)
    What is the Federal Reserve? (Chapter 15)
    Are business cycles related to political elections?
    (Chapter 16)
    Why do countries restrict international trade?
    (Chapter 17)
    What is globalization? (Chapter 18)

    To help you understand these and other issues, we’ve
    tried to boil down economics to its fundamentals—
    the core concepts. Rather than focusing on formal
    economic theories, we have chosen to emphasize relevant applications and policy issues—the same
    issues you read about in today’s newspapers.

    OUR GOALS IN WRITING THE TEXT
    This book is intended for a one-term course in economics, a course that covers the fundamentals of
    micro- and macroeconomics. The text was written
    with several objectives in mind. First, one of our
    goals is to demonstrate the value of economic analy-

    sis in explaining daily events. We also want to show
    how economic analysis can help us understand why
    individuals, business firms, and even governments
    behave as they do. To accomplish this, we relate each
    concept to the individual. For example, we show
    what diminishing marginal returns means to you and
    how money supply affects your paycheck. We
    believe that using real-world examples as illustrations of economic concepts is a more effective learning approach than relying on examples of
    hypothetical products, firms, and people.
    Second, we want to present the world as a global
    economic environment and to present the tools you
    need in order to understand and live in this environment. While other texts ignore or isolate international
    coverage, we fully integrate a global perspective within
    our discussion of the traditional fundamentals of economics. Topics such as rich and poor nations, the creation of the European Central Bank, the change in the
    value of the dollar, and the effect of an exchange rate
    on firms, prices, and employees are all discussed within
    the context of economic analysis.
    A third, overarching goal is to engage students
    with concepts that are currently meaningful. We want
    our readers to learn the fundamentals and to develop
    an economic way of thinking about issues that confront them. We strive to present only the essential
    topics rather than force readers to delve into abstract
    topics so that they become lost in the “forest” and
    lose sight of the “trees.”

    A Focus on Fundamental Questions
    Earlier, we introduced some of the important questions considered in the text. These questions, referred
    to as fundamental questions, provide the organizing
    framework for the text and its accompanying ancillary package. Fundamental Questions, in fact, open
    and organize each chapter, highlighting the critical
    issues. Students should preview the chapters with
    these questions in mind, reading actively for understanding and retention. Each related fundamental
    question also appears in the margin next to the text
    discussion and, with brief answers, in the chapter
    summaries. Finally, fundamental questions are used
    as the integrating framework for the text and the

    xi

    entire ancillary package. For example, brief paragraph answers to each of the questions are found on
    the HM EconSPACE™ student website.





    Global Business Insight: Price Adjusting Vending
    Machines (Chapter 4)
    Global Business Insight: The IMF and the World
    Bank (Chapter 17)

    An Integration of International Issues
    As previously noted, the text incorporates a global
    perspective. In addition to two international chapters—Chapter 17, “Issues in International Trade and
    Finance,” and Chapter 18, “Globalization”—every
    chapter incorporates global examples to provide a
    more realistic picture of the economy. Topics include
    the following:










    Gains from trade (Chapter 1)
    Tariffs, quotas, and bans (Chapter 3)
    Comparative analysis of fiscal policies in different
    countries (Chapter 13)
    “Global money” and international reserve currencies, including a section on informal financial
    markets and a Global Business Insight box on
    Islamic banking (Chapter 14)
    Foreign exchange market intervention as part of
    central bank policy (Chapter 15)
    Business cycles and economic growth issues as
    important macroeconomic policy issues (Chapter
    16)

    CHANGES TO THE FOURTH EDITION
    Our objective of making the subject of economics
    interesting and useful requires constant update of applications and consideration of relevant issues. Principal
    content changes occur in Chapters 2, 3, 7, and 8. To
    this end, Chapters 2 and 3 have been significantly reorganized. Chapters 7 and 8 have been rewritten so as to
    focus on how the government intervenes in markets
    and on rationales for government intervention. All data
    and examples have been updated in the macroeconomic
    chapters. A detailed account of the chapter-by-chapter
    changes in the text can be found in the Transition
    Guide available in the Instructor’s Resource Manual on
    the HM EconSPACE™ instructor website. A few of the
    more important changes are highlighted here:




    A Real-World Framework
    We have developed a real-world framework that
    shows how markets work, focusing on competition
    and the behavior of firms. Instead of becoming
    bogged down in a theoretical discussion of each market structure model, students learn how businesses
    behave, compete, create profit, and attempt to sustain
    profits over time. They learn what business competition means and how it affects their daily lives.
    To further connect the text to the real world, we
    incorporate Economic Insight and Global Business
    Insight boxes, which focus on the policies of today’s
    leaders and the business decisions of real companies
    and governments from around the world. The goal is
    to help students think critically about news stories
    and to respond to them with greater insight. Some
    examples are:








    xii

    Economic Insight: eBay and Online Markets
    (Chapter 7)
    Economic Insight: The Official Poverty Rate
    (Chapter 8)
    Economic Insight: The Value of Homemaker
    Services (Chapter 10)
    Global Business Insight: “Free” Air? (Chapter 1)







    Chapter 2, “Markets and the Market Process,”
    focuses on the market and market allocation.
    Section 1.b, “Alternatives to Market Allocation,”
    is taken from Chapter 2 and more fully developed
    in Chapter 7.
    Chapter 3, “Applications of Demand and Supply,”
    uses what is learned in Chapter 2 to discuss issues
    such as changing tastes, illegal immigration, price
    floors, price ceilings, quotas, and bans. In other
    words, Chapter 3 provides a contrast to the freely
    functioning markets of Chapter 2 to illustrate how
    the government intervenes in markets.
    Chapter 6, now titled “Competition,” is revised
    and reorganized. New sections, “Competition and
    Entry,” “Creating Barriers to Entry,” and “The
    Benefits of Competition,” discuss commodities
    and differentiation, monopoly, competition and the
    shape of demand curves, brands and economic
    scale, and consumer surplus and creative destruction, respectively.
    Chapter 7, “Business, Society, and the Government,”
    focuses on the interactions of business, society, and
    government rather than individual firm strategy.
    The material on pricing strategies has been deleted
    and in its place a discussion of cartels, collusion,
    antitrust, and regulation occurs. The second part of
    the chapter focuses on common issues with market
    allocation.
    Chapter 8, “Social Issues,” applies the content
    of Chapter 7 to global warming and natural
    resources, illicit drugs, discrimination, minimum
    wages, and income inequality.

    Preface





    Chapter 12, “Macroeconomic Equilibrium: Aggregate Demand and Supply,” includes an updated
    Global Business Insight on OPEC and aggregate
    supply, with a new discussion of demand influences
    on the price of oil coming from China.
    Chapter 14, “Money and Banking,” discusses the
    Fed’s recent focus on controlling inflation with
    measured increases in interest rates.

    A COMPLETE TEACHING AND
    LEARNING SYSTEM
    Proven Pedagogical Features
    Reviewers and adopters of the first and second editions have commented very favorably on the learning
    aids within each chapter. All of these features—along
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    guide readers along the way.
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    ideas. The numbering system serves as an outline of
    the chapter, allowing instructors flexibility in assigning
    reading and making review easy for students.
    Fundamental Questions. As described earlier,
    the Fundamental Questions provide an organizing
    framework for the text and ancillary package. They
    have been carefully reviewed and, in some cases,
    revised for this edition in order to reflect the essential
    points for each chapter.
    Recaps. Briefly listing the main points covered, a
    Recap appears at the end of each major section.
    Students are able to quickly review what they have
    just read before going on to the next section.
    Now You Try It. First introduced in the second edition to help students master some of the analytical
    techniques introduced in the text, this feature was
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    checkpoint questions provide an opportunity for students to practice a technique when it is first introduced. Answers are provided at the back of the book
    so that students can immediately check their work and
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    Summary. The summary at the end of each chapter
    is organized according to the list of Fundamental
    Questions. It includes a brief synopsis of the discussion, which helps students answer those questions.
    End-of-Chapter Exercises. A full set of exercises
    at the end of each chapter provides the student with

    Preface

    many additional opportunities for practice—and
    homework. Answers to these exercises are provided
    in the Instructor’s Resource Manual on the HM
    EconSPACE™ instructor website.
    Internet Exercises. Each chapter ends with a reference to the chapter-related Internet Exercises provided
    on the Boyes/Melvin website. Many of these exercises
    link students to real data, examples, and resources such
    as the Federal Trade Commission (Chapter 7), Equal
    Employment Opportunity Commission (Chapter 8),
    and the United Nation Development Programme’s
    Human Development Index (Chapter 10).

    A Pedagogically Sound Art Program
    Economics can be intimidating, which is why we’ve
    incorporated a number of pedagogical devices to help
    students read and interpret graphs. Annotations on
    the art point out areas of particular concern or importance. For example, students can see at a glance what
    parts of the graph illustrate a shortage or a surplus, a
    change in consumption, or consumer surplus.
    Tables that provide data from which graphs are
    plotted are paired with their graphs. A good example
    is Figure 6 in Chapter 2. There, color is used to show
    correlations between the art and the table, and captions clearly explain what is shown in the figure,
    linking them to the text discussion.

    A Well-Integrated Ancillary Package
    One goal for this revision was to make it easier for
    students to practice and apply the new information
    they were learning. Thus, they can review as they
    read a chapter, review again at the end of a chapter,
    and go to the student website for additional practice
    and review questions. Our instructor’s materials support this student-centered approach. To foster the
    development of consistent teaching strategies well
    integrated with the text, the instructor supplements
    follow the same pedagogical format as the text,
    incorporating the Fundamental Questions throughout.


    Online Instructor’s Resource Manual by Davis
    Folsom, University of South Carolina, Beaufort, follows the Fundamental Questions framework. Each
    chapter contains a Lecture Outline and Teaching
    Strategies, Opportunities for Discussion, Answers to
    End-of-Chapter Exercises, and Internet Exercises.
    Each chapter also includes an Active-Learning
    Exercise that instructors can assign as homework or
    conduct in class. The Instructor’s Resource Manual
    is available on the instructor website as a PDF file in
    its complete form or as downloadable and customizable Word files by chapter.

    xiii



    HMTesting CD, powered by Diploma™, allows
    instructors to generate and edit tests easily.
    Developed by the text authors and Davis Folsom
    of the University of South Carolina, Beaufort,
    HMTesting includes over 1,800 questions with a
    mix of difficulty levels and types—multiple choice,
    true/false, and essay. All the questions are also
    referenced according to the in-text numbering system, so instructors can conveniently test down
    to the paragraph level. The program includes an
    online testing feature instructors can use to administer tests via their local area network or over the
    Web. It also has a gradebook feature that lets users
    set up classes, record and track grades from
    tests or assignments, analyze grades, and produce
    class and individual statistics.



    HM EconSPACE™ Instructor Website (located
    at http://college.hmco.com/pic/boyesfund4e) provides a rich store of teaching resources. We offer
    economic and teaching resource links, teaching
    tips, and assignment ideas. Additionally, we offer
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    Press, and an image bank of artwork from the textbook. HM News-Now also comes with enhanced
    PowerPoints that include discussion, polling, and
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    engaging lecture experiences. Instructors can use
    these PPT offerings as is, or they can edit, delete,
    and add them to suit specific class needs.



    HM EconSPACE™ Student Website (located at
    http://college.hmco.com/pic/boyesfund4e) provides an extended learning environment for students
    where materials are carefully developed to complement and supplement each chapter. Students will
    find numerous opportunities to test their mastery of
    chapter content—including glossary terms, online
    (ACE) practice quizzes, and Internet Exercises that
    are linked to the text. Premium content is available
    to students who purchase the text package and HM
    EconSPACE™ student website passkey. Students
    will receive an additional set of resources developed
    to reinforce chapter concepts for a variety of learning styles, including online (ACE+) quizzes, inter-

    xiv

    active Associated Press clips, and Houghton Mifflin
    videos, which help students apply economic concepts to the real world. Passkeys will also provide
    access to electronic flashcards, hangman games,
    and crossword puzzles to allow students to test their
    knowledge of key terms and definitions.

    ACKNOWLEDGMENTS
    We are grateful to our friends and colleagues who
    have so generously given their time, creativity, and
    insight to help us create and revise this text. In particular, we would like to thank Cynthia Conrad, University
    of Hartford; Simeon J. Crowther, California State
    University, Long Beach; Eugene Elander, Plymouth
    State University; Davis Folsom, University of South
    Carolina, Beaufort; Arthur J. Janssen, Emporia State
    University; Vince Marra, University of Delaware;
    Wade E. Martin, Colorado School of Mines; Roger
    Riefler, University of Nebraska; Denise L. Stanley,
    University of Tennessee; Chin-Chyuan Tai, Averett
    University; and Erik D. Craft from the University of
    Richmond for his critical eye and detailed feedback
    during the book’s production. We would also like to
    thank Andrea Worrell of ITT Education Services, Inc.,
    for inspiring us to write the text with students like hers
    in mind. We are grateful to Davis Folsom for his work
    on the Instructor’s Resource Manual and Test Bank
    questions and to Melissa Hardison and Eugenio Suarez,
    who worked with us in developing the Test Bank for the
    first edition. We would like to thank Janet Wolcutt and
    Jim Clark for their work in developing strong in-text
    Study Guides and Joanne Butler for her help with creating the Premium Powerpoint Lecture Slides. We would
    also like to thank Virginia Reilly for her revision of the
    ACE online practice tests and for creating additional
    ACE+ problem sets for the student website and Ed
    Gullason for accuracy checking key ancillary products.
    Finally, we would like to thank Merrill Peterson and
    Matrix Productions for their help in producing this
    book and the staff at Houghton Mifflin Company for
    their support and publishing expertise—specifically,
    Ann West, Kathleen Swanson, Bob Greiner, and
    Megan Hoar.

    Preface

    Fundamentals of Economics

    Part One

    The Price System

    CHAPTER 1

    Economics and the World Around You
    1.
    2.
    3.
    4.
    5.

    Appendix
    CHAPTER 2

    Working with Graphs

    Markets and the Market Process
    1.
    2.
    3.
    4.
    5.
    6.

    CHAPTER 3

    Why study economics?
    What are opportunity costs?
    How are specialization and opportunity costs related?
    Why does specialization occur?
    What are the benefits of trade?

    How are goods and services allocated?
    How does a market process work?
    What is demand?
    What is supply?
    How is price determined by demand and supply?
    What causes price to change?

    Applications of Demand and Supply
    1. In a market system, who determines what is produced?
    2. Why do different people earn different incomes, and why do different jobs pay
    different wages?
    3. Why is illegal immigration an issue?
    4. When the government intervenes in the market by providing a subsidy, what is
    the result?
    5. When the government intervenes in the market by setting a price floor or price
    ceiling, what is the result?
    6. When the government intervenes in the market with a tariff, what is the result?
    7. When the government restricts the quantity that can be sold, what occurs?
    8. What is the effect of a ban on a good, service, or resource?

    3

    Chapter 1

    ?

    Fundamental
    Questions

    1. Why study
    economics?
    2. What are opportunity
    costs?
    3. How are
    specialization and
    opportunity costs
    related?
    4. Why does
    specialization occur?
    5. What are the
    benefits of trade?

    4

    Economics and the World
    Around You

    T

    wo women duked it out. Two men crashed
    their cars. One woman wrote a letter to her
    grandmother and read 150 pages in a paperback while sitting for 31⁄2 hours. Why? Cheap gas. To announce the grand opening
    of Circle K’s first new stores in five years, the company sold gasoline between 10
    AM and noon on a Saturday for the price of $.49 per gallon. Whitney Hamilton got
    in line at 6:30 AM. “I was in line before there was a line. I’ve never seen gas prices
    this low. I don’t think I’ll ever see them this low again.” Vera Lujan drove the 15 or
    so miles from her home, arriving at 8 AM. Seven cars were ahead of her. “I was already on empty, so I put in $1 and drove over,” Lujan said. A 15-gallon limit on the
    fill-ups was enforced. “I think I burned more gas than I’m going to get,” Ben
    Valdez said as he approached the pumps after waiting 90 minutes. A fistfight broke
    out when one woman tried to cut in front of another. John Fecther came for the gas
    but saw the long lines and tried to make a U-turn away from the area. He was hit by
    another vehicle. “I was going to get the heck out of here,” he said as he filled out a
    police report. “People are crazy. You’re only going to save a little.”
    The people in this story decided to purchase 15 gallons of gas at the very low
    price of $.49 per gallon. In so doing they had to wait in line more than an hour and
    in some cases travel several miles to the store. At the time, gas was $1.20 per gallon, so paying the $.49 per gallon saved about $10. But don’t forget the time spent
    and the gas consumed while waiting. These are costs as well. Nevertheless, comparing the costs to the savings, many people decided it was worthwhile to make the
    trip, wait in line, and purchase the gas. And had the price of gas been $2.00 per gallon, more people would have decided to wait in line.
    To some of us, the decision to purchase the gas might seem silly. To others, it is
    very reasonable. But for all of us, the process of deciding whether to purchase the
    gas or not is basically the same. We compare the costs of the decision to the benefits.
    We all have to make choices all the time. Why? Because we don’t have everything we want, and we can’t get everything we want. Since you are reading this
    text, you are most likely taking some type of post–high school economics class.
    Are you at the same time working 40 hours a week, playing tennis or golf, cycling,
    surfing, watching a movie, reading a novel, and socializing with friends? Probably
    not. You simply don’t have time to do it all. You have to select some of these activ-

    Preview

    Part One / The Price System

    ?
    1. Why study economics?

    ities and forgo others. This is what economics is about—trying to understand why
    people do what they do.
    Why are you studying economics? Is it because you are required to, because you
    have an interest in it, or because you are looking for a well-paying job? All of these
    are valid reasons. The college degree is important to your future living standards
    economics is a fascinating subject, as you will see, and an economics degree can
    lead to a good job. What is the difference between a high school diploma and a
    medical degree? About $3.2 million (U.S.), according to the U.S. Census Bureau.
    Someone whose education does not go beyond high school and who works fulltime can expect to earn about $1.2 million between the ages of 25 and 64. Graduating from college and earning advanced degrees translate into much higher lifetime
    earnings: an estimated $4.4 million for doctors, lawyers, and others with professional degrees; $2.5 million for those with master’s degrees; and $2.1 million for
    college graduates. These are average figures and do not take into account the value
    of different majors, but there aren’t very many majors that provide a higher income
    than economics. In the business fields, economics ranks below accounting but
    above marketing, management, and human resources in terms of starting salaries.
    Economics is the highest-paying social science, higher than sociology, psychology,
    and others. The median base salary of business economists in 2007 was around
    $125,000. The highest salaries are earned by those who have a Ph.D.
    A bachelor’s degree in economics prepares you for a career in any number of
    fields—business, banking, the nonprofit sector, journalism, international relations,
    education, and government. An economics degree is also excellent preparation for
    graduate study—in law, business, economics, government, public administration,
    environmental studies, health-care administration, labor relations, urban planning,
    diplomacy, and other areas.
    The reason studying economics can be so useful is that there is a certain logic
    in economics that enables the economist to solve complex problems, problems that
    can be of great importance to society. Economists are concerned with why the
    world is what it is. They examine how individuals and firms make decisions about
    work, consumption, investment, hiring, and pricing goods and services. They study
    how entire economies work and how economies interact, why recessions occur at
    certain times and why economies grow at other times, why some countries have
    much higher living standards than other countries, and why some people are poor and
    others rich. They explore the reasons that baseball players earn multimillion-dollar
    salaries while teachers earn less than $50,000. Studying economics may not provide
    a student with training to work in a specific trade like accounting or nursing, but it
    provides a broad base of skills on which to build. Economics sheds light on how the
    world—and corporations—work, but more importantly, it teaches a student how to
    think.
    An old and tired joke about economists says that if you laid all the economists
    head to toe across the country, they still wouldn’t come to an agreement. Another
    joke along the same lines is the one about a president wanting a one-handed economic advisor because economists were always saying, “On the one hand this
    result and on the other hand that result.” It is true that the general public often

    Chapter 1 / Economics and the World Around You

    5

    fallacy of composition: the
    mistake of assuming that what
    applies to one applies to all

    6

    believes that economists don’t agree about anything and that, therefore, the subject
    of economics has nothing of importance to tell them. The problem is that economists don’t talk much in public about what they agree on, which is almost everything involving the logic of economics, but instead emphasize their disagreements.
    Understandably, the general public and government officials who do not understand economics conclude that their own instincts are as good as anyone else’s.
    Thus, the public and government administrators generalize from personal experience, which often leads them to commit errors of thinking such as the fallacy of
    composition. The fallacy of composition is the faulty logic that maintains that
    what’s true for the individual or the single business is true for the whole economy.
    For instance, standing up at a concert to get a better view is good for one individual, so everyone’s standing up must be better for everyone; restricting free trade is
    good for some workers, so such restrictions have to be good for all workers; providing free health care is good for some people, so offering free health care for
    everyone must be good for a nation as a whole.
    As you will learn in your study of economics, these conclusions are faulty; what’s
    good for one is not necessarily good for many. Economics is often counterintuitive.
    In fact, economics is probably best defined as the study of unintended consequences.
    When you study economics, you learn that there are costs to everything—“there is
    no free lunch.” This is the logic of economics that is often lost among members of
    the general public or government ministers and representatives. The logic for the
    individual is obvious: If you spend more on one thing, you have less to spend on
    something else. The logic for nations should be just as obvious: If the United States,
    Mexico, or any other country is going to spend more on the military, it has to give
    up spending more on something else. Why, then, do countries seemingly spend
    more on some government programs without giving up spending on anything else?
    You will discover how to analyze questions like this one during your study of
    economics.
    The environmentalists who organized and protested at international meetings
    such as the European Economic Summit and the G8 Meetings argue that the world
    is being overrun by greedy corporations that destroy the environment, create global
    warming, and destroy rain forests. They maintain that there should be no pollution
    and no harvesting of trees in the rain forests. Perhaps their arguments have some
    validity, but the environmentalists forget the unintended consequences of the
    policies they desire—there are costs to following these policies. People lose jobs,
    standards of living decline, the poor become even poorer, and so on. It is up to
    the economist to indicate these consequences. People with good intentions
    argued that asbestos can be damaging to people’s health. Consequently, the government imposed strict rules regarding the use and removal of asbestos. These
    rules were supposed to save ten lives each year. The cost of implementing the
    rules per life saved is about $144 million per year. The general public might
    say that a life is worth an infinite amount of money, but the economist would
    point out that spending more than a billion dollars a year to reduce asbestos
    damage has had other consequences. In fact, the consequences of that expenditure
    may harm society more than they help it. The money spent on asbestos removal
    Part One / The Price System

    has to come from somewhere; that means there has to be less spending on other
    things such as safer cars, better health care, and leisure activities. As a consequence
    of reduced spending in other areas, more people could die than the number of
    people that the spending on asbestos removal and restricted use have saved. Many
    people argue that wealthy nations need to provide more aid to poorer nations, that
    such aid will save many destitute people from starvation and disease. The economist has to say, “Let’s look at the costs and benefits of this policy. Such aid could
    have unintended consequences.”
    Perhaps you can see that your study of economics will be interesting and
    provocative. It will challenge some beliefs you now hold. It will also help you build
    skills that will be valuable to your life and in whatever occupation you choose. ■

    1. THE DEFINITION OF ECONOMICS

    ?
    2. What are opportunity
    costs?

    Why are diamonds so expensive while water and air—necessities of life—are
    nearly free? The reason is that diamonds are relatively scarcer; that is, relative to
    the available quantities, more diamonds are wanted than water or air. Of course,
    water is far from free these days. Some people regularly spend over $6 a gallon on
    bottled drinking water, and most homeowners must pay their local government for
    tap water. Even air is not always cheap or free, as noted in the Global Business Insight feature: “‘Free’ Air?”

    1.a. Scarcity and Opportunity Costs
    scarcity: occurs when the
    quantity people want is greater
    than the quantity available at a
    zero price

    The study of economics begins with scarcity. Scarcity refers to the idea that there
    is not enough of something to satisfy everyone who would like that something.
    People have unlimited wants—they always want more than they have or can
    purchase with their incomes. Whether they are wealthy or poor, what they have is
    never enough. Since people do not have everything they want, they must use their

    Global Business Insight

    “Free” Air?

    A

    lthough air might be what we
    describe as a free good, quality, breathable air is not free in
    many places in the world. In fact,
    breathable air is becoming a luxury in
    many places. Consider the Opus Hotel in Vancouver, British Columbia. It
    is the first North American hotel to
    offer hand-held oxygen dispensers in
    every room. These oxygen canisters
    are small enough to fit into a purse
    or briefcase and hold enough air for
    12 minutes of breathing time. Breathing oxygen is said to increase energy,
    improve cognitive performance, and
    reduce the effects of hangovers.

    An oxygen bar
    Vancouver
    where you can inhale
    Dublin
    95 percent pure O2 is
    United
    States
    the latest craze to hit
    Mexico
    City
    Dublin, Ireland, and
    other large cities
    around the world.
    Sniffing concentrated,
    flavored oxygen is a big
    hit in the United States.
    Although these “luxury” purchases of oxygen are inIn this city of 20 million people and
    creasing, less-developed countries
    more than 3 million cars, dust, lead,
    find their sales of oxygen to be more
    and chemicals make the air unsafe
    a matter of necessity. In Mexico City,
    to breathe more than 300 days a
    clean, breathable air is hard to find.
    year. Beijing is no different.

    Chapter 1 / Economics and the World Around You

    7

    opportunity costs: the
    highest-valued alternative that
    must be forgone when a
    choice is made

    tradeoffs: what must be given
    up to acquire something else

    limited time and income to select those things they want most and forgo the rest.
    The choices they make and the manner in which the choices are made explain
    much of why the real world is what it is.
    A choice is simply a comparison of alternatives. For instance if you were deciding whether to buy a new car, what would your alternatives be? They would be
    other makes of automobiles, trucks, even bicycles. They also would be virtually
    anything else on which the money could be spent. When you choose one thing, the
    benefits you might get from other things are forgone. Economists refer to the forgone benefits of the next best alternative as opportunity costs—the highest-valued
    alternative that must be forgone when a choice is made.
    Opportunity costs are part of every decision and activity. Your opportunity costs
    of reading this book are whatever else you could be doing—perhaps watching TV,
    talking with friends, working, or listening to music.
    1.a.1. The Opportunity Cost of Going to School Suppose you decided to
    attend a school where the tuition and other expenses add up to $4,290 per year. Are
    these your total costs? If you answer yes, you are ignoring opportunity costs. If instead of going to school you would have chosen to work full-time, then the benefits
    of full-time employment are part of your opportunity costs. If you could have
    obtained a position with an annual income of $20,800, the actual cost of school is
    the $4,290 of direct expenses plus the $20,800 of forgone salary, or $25,090.
    Each term you must decide whether to register for school. You could work fulltime and not attend school, attend school and not work, or work part-time and attend school. The time you devote to school will decrease as you devote more time
    to work. You trade off hours spent at work for hours spent in school. If you went to
    school full-time, you might earn the highest grades. As you work more hours, you
    gain additional income but might earn lower grades. If this situation occurs, we say
    that you trade off grades and income.
    Societies, like individuals, face scarcities and must make choices, that is, have
    tradeoffs. Because resources are scarce, a nation cannot produce as much of everything as it wants. When it produces more health care, it must forgo the production
    of education, automobiles, or military hardware. When it devotes more of its resources to the military, fewer resources are available to devote to health care, education, or consumer goods.

    1.b. Resources and Income

    resources: inputs used to
    create goods and services
    land: the general category of
    resources encompassing all
    natural resources, land, and
    water
    labor: the general category
    of resources encompassing all
    human activity related to the
    productive process
    capital: the equipment,
    machines, and buildings used
    to produce goods and services
    financial capital: the funds
    used to purchase capital

    8

    Some goods are used to produce other goods. For instance, to make chocolate chip
    cookies we need flour, sugar, chocolate chips, butter, our own labor, and an oven.
    To distinguish between the ingredients of a good and the good itself, we call the ingredients resources. (Resources are also called factors of production and inputs;
    the terms are interchangeable.) The ingredients of the cookies are the resources,
    and the cookies are the goods.
    As illustrated in Figure 1(a), economists have classified resources into three
    general categories: land, labor, and capital.
    1. Land includes all natural resources, such as minerals, timber, and water, as
    well as the land itself.
    2. Labor refers to the physical and intellectual services of people and includes
    the training, education, and abilities of the individuals in a society.
    3. Capital refers to products such as machinery and buildings that are used
    to produce other goods and services. You will often hear the term capital
    used to describe the financial backing for some project to finance some
    business. Economists refer to funds used to purchase capital as financial
    capital.

    Part One / The Price System

    Figure 1
    Flow of Resources and Income
    Three types of resources are used to produce goods and
    services: land, labor, and capital. See 1(a). The owners of
    resources are provided income for selling their services.
    Landowners are paid rent, laborers receive wages, and
    capital receives interest. See 1(b). Figure 1(c) links Figures
    1(a) and 1(b). People use their resources to acquire

    income with which they purchase the goods they want.
    Producers use the money received from selling the goods
    to pay for the use of the resources in making goods. Resources and income flow between certain firms and certain resource owners as people allocate their scarce resources to best satisfy their wants.

    (a) Resources or Factors of Production
    Resources

    Output

    Land
    Labor
    Capital

    Goods
    and
    Services

    (b) Income Creation
    Resources

    Income

    Land

    Rent

    Labor

    Wages

    Capital

    Interest

    (c) Resources and Income Flows
    Payments for Goods ($)
    Goods

    Resource
    Owners

    Producers
    of Goods

    Resource Services
    Payments for Resource Services ($)

    Chapter 1 / Economics and the World Around You

    9

    Income is based on the value of
    resources you own. People
    choose to attend college for
    many reasons, but primarily because their income is likely to be
    higher with a college degree than
    without one. Choosing to attend
    college means choosing not to
    work full-time or not to something else. Every choice involves
    opportunity costs—even attending class and taking notes has
    opportunity costs. It means not
    watching TV, sleeping in, eating,
    or participating in activities or
    work.

    People obtain income by selling their resources or the use of their resources, as
    illustrated in Figure 1(b). Economists define payment to the owners of land as rent,
    payment to people who provide labor services as wages, and payment to owners of
    capital as interest.
    Figures 1(a) and 1(b) are linked because the income that resource owners acquire from selling the use of their resources provides them the ability to buy goods
    and services. And producers use the money received from selling their goods to pay
    for the resource services. In Figure 1(c), the flows of money are indicated along the
    outside arrows, and the flows of goods or resource services are indicated along the
    inside arrows. The resource services flow from resource owners to producers of
    goods in return for income; the flows of goods go from the producers of the goods
    to resource owners in return for the money payment for these goods.

    R E C A P

    10

    1. Scarcity exists when people want more of an item than exists at a zero price.
    2. Choices have to be made because of scarcity. People cannot have or do
    everything they desire all the time. Economics is the study of how people
    choose to use their scarce resources in an attempt to satisfy their wants.
    3. Opportunity costs are the benefits that are forgone due to a choice. When you
    choose one thing you must give up—forgo—others.
    4. Opportunity cost is an individual concept but can be used to demonstrate
    scarcity and choice for a society as a whole.
    5. Goods are produced with resources (also called factors of production and inputs). Economists have classified resources into three categories: land, labor,
    and capital.
    6. Income comes from the ownership of resources.

    Part One / The Price System

    2. SPECIALIZATION AND EXCHANGE
    Are you good with computers or reading or writing? Are you a good golfer or tennis player? Can you fix electrical or plumbing problems or work on large appliances? Even if you are good at all these things, do you do them all? At any moment
    in time individuals are endowed with certain resources and abilities. People can
    choose to be self-sufficient—using their resources and producing what they want
    and need themselves—or they can choose to exchange goods and services with others. By trading, they get more than they can by being self-sufficient.

    2.a. Benefits of Trade
    Consider a very simple example of the benefits of trade. Suppose two people, Maria
    and Able, have the ability to carry out two types of tasks, solving math problems and
    solving economics problems. As shown in Table 1, the two tasks take different time
    and effort from Maria and Able. We will assume that the quality of their work is the
    same—just the quantity differs. If Maria does nothing but work on math, she is able
    to solve 10 problems in an hour; and if she does nothing but economics, she is able
    to solve 10 economics problems in an hour. Her opportunity cost of doing the 10
    math problems is the 10 economics problems she could have done. Able, on the
    other hand, can solve the 10 math problems in an hour but is only able to solve 5
    economics problems in that time. Able’s opportunity cost of doing the 10 math
    problems is the 5 economics problems he could have done instead.
    Suppose Maria and Able would each like to solve 5 math problems, as shown in
    Table 2. Maria would be able to solve 5 math and 5 economics problems while

    Percent of Resources Devoted to

    Table 1
    Choices

    Maria
    Math

    Table 2
    Choices and Trade

    Economics

    Able

    Math

    Economics

    Math

    Economics

    100

    0

    10

    0

    10

    0

    0

    100

    0

    10

    0

    5

    Trading
    Situation

    Maria’s
    Choices

    Able’s
    Choices

    Gain
    from Trade

    Math

    Economics

    Math

    Economics

    Alone,
    no trade

    5

    5

    5

    2.5

    none

    Trade 1 math
    problem for 1
    economics
    problem

    5

    5

    5

    5

    Able 2.5

    Trade 2 math
    problems for 1
    economics
    problem

    5

    7.5

    5

    2.5

    Maria 2.5

    Chapter 1 / Economics and the World Around You

    11

    Able would be able to solve 5 math and 2.5 economics problems. This is shown in
    Table 2 under “Alone, no trade.” Notice that together Maria and Able are able to
    produce 10 math problems and 7.5 economics problems.

    ?
    3. How are specialization
    and opportunity costs
    related?

    ?
    4. Why does specialization
    occur?

    comparative advantage: the
    situation where one individual’s
    opportunity cost is relatively
    lower than another’s

    Now You Try It
    Assume that Maria and Able
    decide to exchange one math
    answer for three-quarters of
    an economics answer. Who
    gains and by how much?

    2.b. Specialization and Comparative Advantage
    Now, suppose Maria and Able decide to exchange answers in order to get more
    done than if each were to work alone. But who will do what? The answer is that the
    person who sacrifices the fewest economics problems to do math problems does
    math problems and the person who sacrifices the fewest math problems to do economics problems does economics problems. In other words, the person with the
    lowest opportunity cost in an activity performs that activity. Even though Maria can
    do math equally as well as Able and can do economics more efficiently than Able,
    Able gives up less by specializing in math. Able only has to give up or forgo half an
    economics problem for each math problem he does while Maria has to give up one
    economics problem for each math problem she does. As a result, they will do better
    having Maria specialize in economics. We say that Able has a comparative advantage in math because his opportunity cost in math is lower than Maria’s, and Maria
    has a comparative advantage in economics because her opportunity cost in economics is lower than Able’s.

    2.c. Gains from Trade
    Since Maria, by herself, can do one math problem at the same rate as she can do
    one economics problem, she will require at least one economics answer from Able
    to be willing to give him one math answer. Able can solve two math problems for
    each economics problem, so he will have to get at least half an economics answer
    from Maria to give her a math answer.
    If they should exchange one math answer for one economics answer, then, as
    shown in row 2 (1:1) of Table 2, Maria and Able are each able to get five math and
    five economics answers. Although Maria is no better off than if she had done her
    own work, Able is 2.5 economics answers better off. These additional 2.5 answers
    are called the gains from trade.

    gains from trade: the
    additional amount one can
    consume by trading

    The fruit of the prickly pear cactus is popular in salads and
    drinks. Recently, the extract from
    the cactus leaves has been found
    to relieve some of the symptoms
    of diabetes. Physicians in Mexico
    and Japan prescribe the extract
    as a substitute for insulin in
    some cases and as an enhancement to insulin in others. Though
    the prickly pear cactus grows in
    the southwestern United States
    as well, the harvesting of the
    cacti occurs mainly in Mexico because most of the prickly pear
    cactus forests are in Mexico, and
    the labor-intensive harvesting
    process is less costly in Mexico
    than it would be in the United
    States. Mexico has a comparative
    advantage in the harvesting of
    the cacti.

    12

    Part One / The Price System

    ?
    5. What are the benefits of
    trade?

    R E C A P

    If, instead of one for one, they agree to exchange two math answers for each
    economics answer, then, as shown in row 3 (2:1) of Table 2, Maria gains 2.5 economics answers while Able is no better off than if he had done the problems himself. At any rate of exchange between 1:1 and 2:1, both Maria and Able will gain
    from specializing and exchanging answers.
    In virtually every trading situation, both parties gain from voluntary exchange;
    the amount each party gains—that is, the amount both parties together get that is
    larger than the sum of what each could have produced without trade—is called the
    gains from trade.
    This simple example illustrates how the real world works. People focus on what
    they do best and then trade with others. You cook and your roommate cleans; you
    work on computers and let someone else fix your car; you purchase groceries, letting
    someone else grow the food. Why do specialization and trade occur? Because people always want more than they currently have, and specializing and then trading
    enables them to get more than not specializing and not trading. This is one of the
    fundamental assumptions of economics: people behave in ways that give them the
    greatest benefit—the greatest happiness—given their limited resources. In doing
    this, people compare the costs and benefits of an action and choose to undertake the
    action if, in their opinion, the benefits exceed the costs. Thus, people will look at
    making a trade if what they give up (their costs) is less than what they gain (their
    benefits).
    We have to decide how to use our own scarce resources. We must choose where
    to devote our energies. Few of us are jacks-of-all-trades. Nations, similarly, have
    limited amounts of resources and must choose where to devote those resources.
    Specializing in those activities that require us to give up the smallest amount of
    other things—in other words, where we have a comparative advantage—enables us
    to obtain more than trying to do everything ourselves. A plumber does plumbing
    and leaves teaching to the teachers. The teacher teaches and leaves electrical work
    to the electrician. Grenada specializes in spice production and leaves manufacturing to the United States. But if we specialize, how do we get the other things we
    want? The answer is that we trade.

    1. Exchange occurs because all parties involved believe the exchange can be
    beneficial.
    2. Opportunity cost is the amount of one good or service that must be given up
    to obtain one additional unit of another good or service.
    3. The rule of specialization is that the individual (firm, region, or nation) will
    specialize in the activity in which it has the lowest opportunity cost.
    4. Specialization and trade enable individuals, firms, and nations to get more
    than they could without specialization and trade.
    5. By specializing in an activity that one does relatively better than other activities,
    one can trade with others and gain more than if one carried out all activities oneself. This additional amount is referred to as gains from trade.

    Chapter 1 / Economics and the World Around You

    13

    SUMMARY
    ?

    1.

    Why study economics?

    ?

    The objective of economics is to understand why the
    real world is what it is.
    Economics is the study of how people choose to
    allocate scarce resources to satisfy their unlimited
    wants.
    Scarcity is universal; it applies to anything people
    would like more of than is available at a zero price.
    Because of scarcity, choices must be made.

    2.

    3.

    ?

    4.

    5.

    ?

    6.

    What are opportunity costs?

    Opportunity costs are the forgone opportunities of the
    next best alternative. Choice means both gaining
    something and giving up something. When you
    choose one option, you forgo all others. The benefits
    of the next best alternative are the opportunity costs of
    your choice.

    ?

    How are specialization and opportunity costs
    related?

    Comparative advantage is when one person (one firm,
    one nation) can perform an activity or produce a good
    with fewer opportunity costs than someone else.
    Why does specialization occur?

    Comparative advantage accounts for specialization.
    We specialize in the activities in which we have the
    lowest opportunity costs, that is, in which we have a
    comparative advantage.
    What are the benefits of trade?

    7.

    Specialization and trade enable those involved to acquire more than they could by not specializing and engaging in trade. The additional amount acquired from
    trade is called the gains from trade.

    5.

    Use economics to explain why people contribute to
    charities.
    In presidential campaigns, candidates always seem to
    make more promises than they can fulfill: more and
    better health care; a better environment; only minor
    reductions in defense; better education; better roads,
    bridges, sewer systems, and water systems; and so on.
    What economic concept is ignored by the candidates?
    Perhaps you’ve heard of the old saying “There is no
    such thing as a free lunch.” What does it mean? If
    someone invites you to a lunch and offers to pay for it,
    is it free for you?
    During China’s Cultural Revolution in the late 1960s
    and early 1970s, many people with a high school or
    college education were forced to move to farms and
    work in the fields. Some were common laborers for
    eight or more years. What does this policy say about
    specialization? Would you predict that the policy
    would lead to an increase in output?

    EXERCISES
    1.

    Explain why each of the following is or is not an economic good.
    a. Steaks
    d. Garbage
    b. Houses
    e. T-shirts
    c. Cars
    It is well documented in scientific research that
    smoking is harmful to our health. Smokers have
    higher incidences of coronary disease, cancer, and
    other catastrophic illnesses. Knowing this, about 30
    percent of young people begin smoking and about 25
    percent of the U.S. population smokes. Are the people
    who choose to smoke irrational? What do you think
    of the argument that we should ban smoking in order
    to protect these people from themselves?
    Use economics to explain why diamonds are more
    expensive than water when water is necessary for
    survival and diamonds are not.
    Use economics to explain why people leave tips in the
    following two cases: (a) at a restaurant they visit often; (b) at a restaurant they visit only once.

    2.

    3.

    4.

    Internet
    Exercise

    14

    6.

    7.

    8.

    Use the Internet to examine U.S. international trade.
    Go to the Boyes/Melvin, Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise
    link for Chapter 1. Now answer the questions found on the Boyes/Melvin website.

    Part One / The Price System

    Study Guide for Chapter 1
    Key Term Match

    2

    Match each term with its correct definition by placing
    the appropriate letter next to the corresponding number.
    A.
    B.
    C.
    D.
    E.
    F.

    fallacy of composition
    scarcity
    opportunity costs
    tradeoffs
    resources
    land

    labor
    capital
    financial capital
    comparative
    advantage
    K. gains from trade

    Quick-Check Quiz
    1

    ■ a. Janine; her opportunity cost is lower
    ■ b. Janine; her opportunity cost is higher
    ■ c. Robert; his opportunity cost is lower
    ■ d. Robert; his opportunity cost is higher
    ■ e. Janine; because she is better able to afford the

    G.
    H.
    I.
    J.

    1. the amount that trading partners benefit beyond
    the sum of what each could have produced without the trade
    2. the physical and intellectual services of people, including the training, education, and abilities of the
    individuals in a society
    3. goods used to produce other goods—i.e., land, labor, and capital
    4. products such as machinery and equipment that
    are used in production
    5. the shortage that exists when less of something is
    available than is wanted at a zero price
    6. the ability to produce a good or service at a lower
    opportunity cost than it would cost someone else
    to produce it
    7. all natural resources, such as minerals, timber, and
    water, as well as the land itself
    8. the highest-valued alternative that must be
    forgone when a choice is made
    9. funds used to purchase capital
    10. the giving up of one good or activity in order to
    obtain some other good or activity
    11. the mistake of assuming that what is good for one
    is good for all

    Ecomomics is the study of the relationship between
    ■ a. people’s unlimited wants and their scarce
    resources.
    ■ b. people’s limited wants and their scarce
    resources.
    ■ c. people’s limited wants and their infinite
    resources.
    ■ d. people’s limited income and their scarce
    resources.
    ■ e. human behavior and limited human wants.

    Chapter 1 / Economics and the World Around You

    Janine is an accountant who makes $30,000 a year.
    Robert is a college student who makes $8,000 a year.
    All other things being equal, who is more likely to
    stand in a long line to get a cheap concert ticket?

    cost of the ticket
    3

    Which of the following should not be considered an
    opportunity cost of attending college?
    ■ a. money spent on living expenses that are the
    same whether or not you attend college
    ■ b. lost salary
    ■ c. business lunches
    ■ d. interest that could have been earned on your
    money had you put the money into a savings account instead of spending it on tuition
    ■ e. opportunities sacrificed in the decision to attend
    college

    4

    Exchange among people occurs because
    ■ a. everyone involved believes they will gain.
    ■ b. one person gains, and the others lose.
    ■ c. only one person loses while everyone else gains.
    ■ d. people have no other choices.
    ■ e. the government requires it.

    5

    You have a comparative advantage in producing
    something when you
    ■ a. have a higher opportunity cost than someone
    else.
    ■ b. have a special talent.
    ■ c. have a lower opportunity cost than someone
    else.
    ■ d. have learned a useful skill.
    ■ e. have the same opportunity cost as someone else.

    Use the following table to answer study questions 6
    through 10.
    On a 10-acre farm, one farmer can produce these quantities of corn or wheat in Alpha and Beta.
    Alpha
    Beta

    Corn
    200
    100

    Wheat
    400
    300

    15

    6

    The opportunity cost of corn in Beta is
    ■ a. 300 wheat.
    ■ b. 1 wheat.
    ■ c. 3 wheat.
    ■ d. 100 corn.
    ■ e. .5 corn.

    2

    Janine decides to buy a ticket to a classical music concert. The ticket costs $10. She spends 30 minutes
    driving to the ticket office, 60 minutes waiting in line,
    and 30 minutes eating a snack after buying the ticket.
    List her opportunity costs of getting the ticket.

    7

    The opportunity cost of corn in Alpha is
    ■ a. 400 wheat.
    ■ b. 2 wheat.
    ■ c. 4 wheat.
    ■ d. 100 corn.
    ■ e. .5 corn.

    3

    Exchange occurs because
    (one person, everyone involved) believes the exchange can be beneficial.

    4

    It is in your best interest to specialize in the area

    8

    9

    The opportunity cost of wheat in Beta is
    ■ a. .333 corn.
    ■ b. 1 wheat.
    ■ c. 3 wheat.
    ■ d. 300 wheat.
    ■ e. .5 corn.

    in which your opportunity costs are
    (highest, constant, lowest).
    5

    A person or even a nation has a comparative advantage
    in those activities in which it has
    (the highest, constant, the lowest) opportunity costs.

    6

    The opportunity cost of wheat in Alpha is
    ■ a. 400 wheat.
    ■ b. 2 wheat.
    ■ c. 4 wheat.
    ■ d. 100 corn.
    ■ e. .5 corn.

    Chris works at a part-time job that pays $15 per hour.
    He wants a new shirt to wear next Friday night. He
    can buy one at the mall for $30, or he can make one
    (using materials he already has) with five hours of
    labor.
    a. If Chris makes the shirt himself, how many hours
    will he spend on making the shirt?

    10 Which of the following statements is (are) true?

    b. If Chris works at his job and uses the money to
    buy a shirt, how many hours of work will it take
    him to earn the money to buy the shirt?

    ■ a. Alpha has a comparative advantage in corn, and
    Beta has a comparative advantage in wheat.

    ■ b. Alpha has a comparative advantage in wheat,
    and Beta has a comparative advantage in corn.

    ■ c. Alpha has a comparative advantage in both corn

    c. What do economists call the three hours Chris
    saved by working at his job and trading his money
    for a shirt instead of making it himself?

    and wheat.
    ■ d. Beta has a comparative advantage in both corn
    and wheat.
    ■ e. Neither has a comparative advantage in anything.
    7

    Practice Questions and Problems
    1

    List the three categories of resources and the payments associated with each.

    The following table shows the number of shirts or ties
    that two tailors, Joe and Harry, can make in one day.
    Shirts
    Ties
    Joe
    1
    4
    Harry
    2
    6
    a. Joe’s opportunity cost of making one shirt is
    .
    b. Joe’s opportunity cost of making one tie is
    .

    16

    Part One / The Price System

    c. Harry’s opportunity cost of making one shirt is

    It’s become part of Wichita lore. Folks in these
    parts are nutty about parking.
    They want it free. They want it at the front
    door of wherever they’re going. They refuse to
    look for a parking space anywhere for more
    than eight or ten seconds. And they think the
    downtown Wichita parking situation is horrible.
    The fact is, there’s plenty of parking in the
    city’s core. About 20,000 people work downtown. There are almost 19,000 parking spaces.
    That nearly 1-to-1 ratio is better than other
    cities in the region such as Oklahoma City, and
    it’s just as good as Topeka. And the average distance a person has to walk is about a block.
    That’s better than similar-sized cities.

    .
    d. Harry’s opportunity cost of making one tie is
    .
    e. Who has a comparative advantage in making
    shirts?
    f. Who has a comparative advantage in making ties?
    g. Who should specialize in making ties?
    h. Who should specialize in making shirts?

    Exercises and Applications
    I

    II

    Scarce Parking in Wichita? The following is an excerpt from a Wichita, Kansas, newspaper, the Wichita
    Eagle:

    The editorial laments that people don’t go downtown for
    activities because they think they will have trouble parking. Relying on information in the editorial, do you think
    that parking spaces can be considered a scarce resource in
    downtown Wichita?

    Resource and Income Flows Complete the figure

    below:

    III Opportunity Costs

    Chapter 1 / Economics and the World Around You

    ✸✔

    ACE s

    Mr. Safi and Mr. Nohr are
    neighbors. Mr. Safi makes $200 an hour as a consultant while Mr. Nohr makes $10 an hour as an aerobics
    instructor. The men are complaining that the grass on
    their lawns has grown so fast due to recent rainy
    weather that it is hard to keep their lawns looking
    nice. Mr. Nohr mows his lawn himself. Mr. Safi comments that he hires a neighbor’s child to cut his grass
    “because it is too expensive for me to cut it myself.”
    Explain Mr. Safi’s comment.

    -test
    elf

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    17

    Appendix to
    Chapter 1

    Working with Graphs

    1. READING AND CONSTRUCTING GRAPHS
    It is important to understand how the axes (the horizontal and vertical lines) are
    used and what they measure. Let’s begin with the horizontal axis, the line running
    across the page in a horizontal direction. Notice in Figure 1(a) that the line is divided into equal segments. Each point on the line represents a quantity, or the value
    of the variable being measured. For example, each segment could represent 10
    years or 10,000 pounds of diamonds or some other value. Whatever is measured,
    the value increases from left to right, beginning with negative values, going on to
    zero, which is called the origin, and then moving on to positive numbers.
    A number line in the vertical direction can be constructed as well, also shown in
    Figure 1(a). Zero is the origin, and the numbers increase from bottom to top. Like the
    horizontal axis, the vertical axis is divided into equal segments; the distance between 0
    and 10 is the same as the distance between 0 and 10, between 10 and 20, and so on.
    Putting the horizontal and vertical lines together lets us express relationships between two variables graphically. The axes cross, or intersect, at their origins, as shown
    in Figure 1(a). From the common origin, movements to the right and up, in the area—
    called a quadrant—marked I, are combinations of positive numbers; movements to
    the left and down, in quadrant III, are combinations of negative numbers; movements
    to the right and down, in quadrant IV, are negative values on the vertical axis and positive values on the horizontal axis; and movements to the left and up, in quadrant II,
    are positive values on the vertical axis and negative values on the horizontal axis.
    Economic data are typically positive numbers: the unemployment rate, the inflation rate, the price of something, the quantity of something produced or sold, and so
    on. Because economic data are usually positive numbers, the only part of the coordinate system that usually comes into play in economics is the upper right portion,
    quadrant I. That is why economists may simply sketch a vertical line down to the
    origin and then extend a horizontal line out to the right, as shown in Figure 1(b).
    When data are negative, the other quadrants of the coordinate system may be used.

    1.a. Constructing a Graph from a Table
    Now that you are familiar with the axes, that is, the coordinate system, you are
    ready to construct a graph using the data in the table in Figure 2. The table lists a
    series of possible price levels for a personal computer (PC) and the corresponding
    number of PCs people choose to purchase. The data are only hypothetical; they are
    not drawn from actual cases.
    The information given in the table is graphed in Figure 2. We begin by marking
    off and labeling the axes. The vertical axis is the list of possible price levels. We begin at zero and move up the axis at equal increments of $1,000. The horizontal axis
    is the number of PCs sold. We begin at zero and move out the axis at equal increments of 1,000 PCs. According to the information presented in the table, if the price
    18

    Part One / The Price System

    Figure 1
    The Axes, the Coordinate System, and the Positive
    Quadrant
    Figure 1(a) shows the vertical and horizontal axes. The
    horizontal axis has an origin, measured as zero, in the
    middle. Negative numbers are to the left of zero, positive
    numbers to the right. The vertical axis also has an origin in
    the middle. Positive numbers are above the origin; negative numbers are below. The horizontal and vertical axes
    together show the entire coordinate system. Positive
    numbers are in quadrant I, negative numbers in quadrant

    III, and combinations of negative and positive numbers in
    quadrants II and IV.
    Figure 1(b) shows only the positive quadrant. Because
    most economic data are positive, often only the upper
    right quadrant, the positive quadrant, of the coordinate
    system is used.

    (a) The Coordinate System

    (b) The Positive Quadrant

    Vertical Axis

    Vertical Axis

    20

    20

    II

    I

    I
    10

    10

    Origin
    Horizontal Axis

    Horizontal Axis
    –20

    –10

    10

    20

    0

    10

    20

    –10

    III

    IV
    –20

    is $10,000, no one buys a PC. The combination of $10,000 and 0 PCs is point A on
    the graph. To plot this point, find the quantity zero on the horizontal axis (it is at the
    origin), and then move up the vertical axis from zero to a price level of $10,000.
    (Note that we have measured the units in the table and on the graph in thousands.)
    At a price of $9,000, there are 1,000 PCs purchased. To plot the combination of
    $9,000 and 1,000 PCs, find 1,000 units on the horizontal axis and then measure up
    from there to a price of $9,000. This is point B. Point C represents a price of $8,000
    and 2,000 PCs. Point D represents a price of $7,000 and 3,000 PCs. Each combination of price and PCs purchased listed in the table is plotted in Figure 2.
    The final step in constructing a line graph is to connect the points that are plotted. When the points are connected, the straight line slanting downward from left to
    right in Figure 2 is obtained. It shows the relationship between the price of PCs and
    the number of PCs purchased.

    1.b. Interpreting Points on a Graph
    Let’s use Figure 2 to demonstrate how points on a graph may be interpreted. Suppose the current price of a PC is $6,000. Are you able to tell how many PCs are

    Appendix to Chapter 1 / Working with Graphs

    19

    Figure 2
    Prices and Quantities Purchased
    The information given in the table is graphed below. We
    begin by marking off and labeling the axes. The vertical
    axis is the list of possible price levels. The horizontal axis
    is the number of PCs purchased. Beginning at zero, the
    axes are marked at equal increments of 1,000. According
    to the information presented in the table, if the price level
    is $10,000, no PCs are purchased. The combination of

    Point

    Price per PC
    (thousands
    of dollars)

    A

    $10

    0

    B

    9

    1

    C

    8

    2

    D

    7

    3

    E

    6

    4

    F

    5

    5

    G

    4

    6

    H

    3

    7

    2

    I

    2

    8

    1

    J

    1

    9

    K

    0

    10

    10

    A
    B

    Price per PC
    (thousands of dollars)

    9

    C

    8

    D

    7

    E

    6

    F

    5

    G

    4
    3

    0

    H

    Rise

    Number of PCs
    Purchased
    (thousands)

    $10,000 and 0 PCs is point A on the graph. At a price of
    $9,000, there are 1,000 PCs purchased. This is point B.
    The final step in constructing a line graph is to connect
    the points that are plotted. When the points are connected, the straight line slanting downward shows the relationship between the price of PCs and the number of
    PCs purchased.

    I
    J
    Run

    1

    2

    3

    4

    5

    6

    7

    K
    8

    9

    10

    Number of PCs Purchased
    (thousands)

    being purchased at this price? By tracing that price level from the vertical axis over
    to the curve and then down to the horizontal axis, you find that 4,000 PCs are purchased. You can also find what happens to the number purchased if the price falls
    from $6,000 to $5,000. By tracing the price from $5,000 to the curve and then
    down to the horizontal axis, you discover that 5,000 PCs are purchased. Thus,
    according to the graph, a decrease in the price from $6,000 to $5,000 results in
    1,000 more PCs being purchased.

    1.c. Shifts of Curves
    Graphs can be used to illustrate the effects of a change in a variable not represented
    on the graph. For instance, the curve drawn in Figure 2 shows the relationship between the price of PCs and the number pf PCs purchased. When this curve was
    drawn, the only two variables that were allowed to change were the price and the
    number of computers. However, it is likely that people’s incomes determine their
    reaction to the price of computers as well. An increase in income would enable
    more people to purchase computers. Thus, at every price more computers would be
    purchased. How would this be represented? As an outward shift of the curve, from
    points A, B, C, etc., to A, B, C, and so on, as shown in Figure 3.
    Following the shift of the curve, we can see that more PCs are purchased at each
    price than was the case prior to the income increase. For instance, at a price of

    20

    Part One / The Price System

    Figure 3
    10

    A'
    B

    9

    Price per PC
    (thousands of dollars)

    An increase in income allows more
    people to purchase PCs at each
    price. At a price of $8,000, for instance, 4,000 PCs are purchased
    rather than 2,000.

    A

    B'
    C

    8

    C'
    D

    7

    D'
    E

    6

    E'
    F

    5

    F'
    G

    4

    G'
    H

    Rise

    Shift of Curve

    3

    H'
    I

    2

    J

    1
    0

    I'
    J'

    Run
    1

    2

    3

    4

    5

    6

    7

    8

    9

    10

    11

    Number of PCs Purchased
    (thousands)

    $8,000 the increased income allows 4,000 PCs to be purchased rather than 2,000.
    The important point to note is that if some variable that influences the relationship
    shown in a curve or line graph changes, then the entire curve or line changes; that
    is, it shifts.

    2. APPLICATION: THE PPC
    Production Possibilities curve
    (PPC). a graphical
    representation showing the
    maximum quantity of goods
    and services thhat can be
    produced using limited
    resources to the fullest extent
    possible, shows the maximum
    output that can be produced
    using resources fully and
    efficiently.

    The production possibilities curve (PPC) shows all possible combinations of two
    products that can be produced with a limited quantity and quality of resources. In
    this case, Maria and Able had limited amounts of time and certain abilities to carry
    out homework assignments. A nation also has a PPC based on its quantity and quality of resources and its technologies. Consider a nation deciding how much of its
    resources are to be devoted to national defense and how much to domestic, or nondefense, goods and services. In Figure 4, units of defense goods and services are
    measured on the vertical axis, and units of nondefense goods and services are measured on the horizontal axis.
    If all resources are allocated to producing defense goods and services, then 200
    million units can be produced, but the production of nondefense goods and services
    will cease. The combination of 200 million units of defense goods and services and
    0 units of nondefense goods and services is point A1, a point on the vertical axis. At
    175 million units of defense goods and services, 75 million units of nondefense
    goods and services can be produced (point B1). Point C1 represents 125 million
    units of nondefense goods and services and 130 million units of defense goods.
    Point D1 represents 150 million units of nondefense goods and services and 70 million units of defense goods and services. Point E1, a point on the horizontal axis,
    shows the combination of no production of defense goods and services and total
    production of nondefense goods and services.
    The PPC is a picture of the tradeoffs facing society. A production possibilities
    curve shows that more of one type of good can be produced only by reducing the
    quantity of other types of goods that are produced; it shows that a society has
    scarce resources.

    Appendix to Chapter 1 / Working with Graphs

    21

    Figure 4
    The Production Possibilities Curve
    the underutilization of resources. More of one type of
    good and less of another could be produced, or more of
    both types could be produced. Point G1 represents an impossible combination. There are insufficient resources to
    produce quantities lying beyond the curve.

    Nondefense Goods
    and Services
    (millions of units)

    Combination

    Defense Goods
    and Services
    (millions of units)

    A1

    200

    0

    B1

    175

    75

    C1

    130

    125

    D1

    70

    150

    E1

    0

    160

    F1

    130

    25

    G1

    200

    75

    Defense Goods and Services (millions of units)

    With a limited amount of resources, only certain combinations of defense and nondefense goods and services can
    be produced. The maximum amounts that can be produced, given various tradeoffs, are represented by points
    A1 through E1. Point F1 lies inside the curve and represents

    225
    200

    G1
    Impossible Combination

    A1

    B1

    175
    150
    125

    F1
    Underutilization

    C1

    100

    D1

    75
    50
    25
    0

    E1
    25

    50

    75

    100 125 150 175 200

    Nondefense Goods and Services (millions of units)

    2.a. Interpreting Graphs: Points Inside the Production
    Possibilities Curve
    Suppose a nation produces 130 million units of defense goods and services and 25
    million units of nondefense goods and services. That combination, point F1 in Figure 4, lies inside the production possibilities curve. A point lying inside the production possibilities curve indicates that resources are not being fully or efficiently
    used. If the existing work force is employed only 20 hours per week, it is not being
    fully used. If two workers are used when one would be sufficient—say, two people
    in each Domino’s Pizza delivery car—then resources are not being used efficiently.
    If there are resources available for use, society can move from point F1 to a point
    on the PPC, such as point C1. The move would gain 100 million units of nondefense goods and services with no loss of defense goods and services.

    2.b. Interpreting Graphs: Points Outside the Production
    Possibilities Curve
    Point G1 in Figure 4 represents the production of 200 million units of defense
    goods and services and 75 units of nondefense goods and services. Point G1, however, represents the use of more resources than are available; it lies outside the production possibilities curve. Unless more resources can be obtained or the quality of
    resources improved so that the nation can produce more with the same quantity
    of resources, there is no way the society can currently produce 200 million units of
    defense goods and 75 million units of nondefense goods.

    2.c. Shifts of the Production Possibilities Curve
    As we have seen, graphs can be used to illustrate the effects of a change in a variable not explicitly shown on the graph. For instance, if a nation obtains more

    22

    Part One / The Price System

    resources, points outside its current production possibilities curve become attainable. Suppose a country discovers new sources of oil within its borders and is able
    to greatly increase its production of oil. Greater oil supplies would enable the country to increase production of all types of goods and services.
    Figure 5 shows the production possibilities curve before (PPC1) and after
    (PPC2) the discovery of oil. Curve PPC1 is based on the data given in the table in
    Figure 4. Curve PPC2 is based on the data given in the table in Figure 5, which
    shows the increase in the production of goods and services that results from the increase in oil supplies. The first combination of goods and services on PPC2, point
    A2, is 220 million units of defense goods and 0 units of nondefense goods. The second point, B2, is a combination of 200 million units of defense goods and 75 million units of nondefense goods. Points C2 through F2 are the combinations shown
    in the table of Figure 5. Connecting these points yields the bowed-out curve, PPC2.
    Because of the availability of new supplies of oil, the nation is able to increase the
    production of all goods, as shown by the shift from PPC1 to PPC2. A comparison
    of the two curves shows that more goods and services for both defense and nondefense are possible along PPC2 than along PPC1.
    The outward shift of the PPC can be the result of an increase in the quantity of
    resources, but it also can occur because the quality of resources improves. For instance, a technological breakthrough could conceivably improve the way that communication occurs, thereby requiring fewer people and machines and less time to
    produce the same quantity and quality of goods. The work force could become
    more literate, thereby requiring less time to produce the same quantity and quality
    of goods. Each of these quality improvements in resources could lead to an outward shift of the PPC.
    Curves shift when things that affect the relationship between the variables
    measured on the graphs change. The PPC measures combinations of two different
    types of products that a country could produce. When technology improves, then
    the combinations of the two goods that could be produced changes, and the PPC
    shifts outward.

    Figure 5
    A Shift of the Production Possibilities Curve
    enables the society to produce more of both types of
    goods. The curve shifts out, away from the origin.

    Nondefense Goods
    and Services
    (millions of units)

    Combination

    Defense Goods
    and Services
    (millions of units)

    A2

    220

    0

    B2

    200

    75

    C2

    175

    125

    D2

    130

    150

    E2

    70

    160

    F2

    200

    165

    Defense Goods and Services (millions of units)

    Whenever everything else is not constant, the curve shifts.
    In this case, an increase in the quantity of a resource

    225
    200

    A2
    B2

    A1

    C2

    B1

    175

    PPC 2

    PPC 1

    150

    D2

    C1

    125
    100

    E2

    75

    D1

    50
    25
    0

    E1
    25

    50

    75

    F2

    100 125 150 175 200

    Nondefense Goods and Services (millions of units)

    Appendix to Chapter 1 / Working with Graphs

    23

    2.d. Gains from Trade
    Let’s use the trading problem between Maria and Able discussed in Chapter 1 to illustrate the use of the PPC graph. Review Table 1 Choices on page 11.
    Figure 6 shows Maria’s and Able’s production possibilities curves based on the
    information given in the table. The output per house has been plotted for each.
    Maria’s PPC is given in the graph on the left. It indicates that she can solve 10 economics problems and no math problems, 10 math problems and no economics
    problems, or any combination lying along the line. Able, similarly, can produce
    those combinations shown along the line in the figure on the right. Maria can produce only those combinations along her production possibilities line or combinations inside the line. Able can also produce only those combinations along or inside
    his production possibilities line. The production possibility curves in this example
    are actually straight lines. For our purposes, the difference between a straight line
    PPC and a bowed PPC does not matter. Both shapes illustrate the idea that the combinations of two products along the PPC are the maximum a person or a nation can
    produce given current limited resources.
    Maria and Able could each solve both the economics and the math problems, or
    one could solve economics problems, and the other could do the math problems.
    Remember, if each specializes in an area in which each has a comparative advantage (Maria solves the economics problems, and Able completes the math problems), they can then trade to get what they want.
    Suppose Able agrees to do math problems for Maria if she will do economics
    problems for him. Then Maria ends up with more completed math and economics
    problems for herself than she could do alone, while Able also gets more math and
    economics problems than he alone could do. Gains from trade are shown by the
    combinations of economics and math problems that lie above the production possibility curves.

    Figure 6
    Gains from Trade

    (a) Maria

    (b) Able
    10

    Economics Problems

    Economics Problems

    10

    5

    0

    2

    4

    6

    Math Problems

    24

    8

    10

    5

    0

    2

    4

    6

    8

    10

    Math Problems

    Part One / The Price System

    1027675_Ch01_p002-025.qxd 19/10/07 11:54 AM Page 25

    SUMMARY
    1.

    Health
    Care

    Food

    Health
    Care

    Food

    100
    50
    0

    1,000
    500
    0

    0
    7
    10

    500
    250
    0

    0
    3
    7

    Most economic data are positive numbers, so often
    only the upper right quadrant of the coordinate system
    is used in economics.

    Percent of
    Effort
    Devoted to
    Health Care

    EXERCISES
    1.

    Plot the data listed in the table below.
    a. Measure price along the vertical axis and quantity
    along the horizontal axis and plot the first two
    columns.
    b. Show what quantity is sold when the price is $550.
    c. Directly below the graph in part a, plot the data in
    columns 2 and 3. In this graph, measure quantity
    on the horizontal axis and total revenue on the vertical axis.
    d. What is total revenue when the price is $550? Will
    total revenue increase or decrease when the price is
    lowered?
    Price

    $1,000
    900
    800
    700
    600
    500
    400
    300
    200
    100

    2.

    Quantity Sold

    Total
    Revenue

    200
    400
    600
    800
    1,000
    1,200
    1,400
    1,600
    1,800
    2,000

    200,000
    360,000
    480,000
    560,000
    600,000
    600,000
    560,000
    480,000
    360,000
    200,000

    2.

    Haiti

    Cuba

    Plot the PPC given by the following data.
    Combination
    A
    B
    C
    D
    E

    Health Care

    All Other Goods

    0
    25
    50
    75
    100

    100
    90
    70
    40
    0

    a. Calculate the opportunity cost of each combination
    compared to the combination before. Compare A to
    B, B to C, C to D, and D to E.
    b. Suppose a second nation has the following PPC.
    Plot the PPC. Are you able to define which nation
    has a comparative advantage in which activity?
    Combination
    A
    B
    C
    D
    E

    Health Care

    All Other Goods

    0
    20
    40
    60
    65

    50
    40
    25
    5
    0

    Listed below are the production possibility curves for
    two countries producing health care and food. If they
    devote all resources to health care, Haiti can care for
    1,000 people a month, while Cuba can care for 500. If
    they split their resources 50-50, Haiti can care for 500
    people and produce 7 tons of food, while Cuba can
    care for 250 and produce 3 tons of food. Putting all resources into food, Haiti can produce 10 tons, while
    Cuba can produce 7.
    a. Plot Haiti’s and Cuba’s production possibility curves.
    b. Can you see any possible gains from trade that
    might occur?
    c. What would Haiti specialize in? What would Cuba
    specialize in?

    Appendix to Chapter 1 / Working with Graphs

    Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

    25

    Chapter 2

    ?

    Fundamental
    Questions

    1. How are goods and
    services allocated?
    2. How does a market
    process work?
    3. What is demand?
    4. What is supply?
    5. How is price
    determined by
    demand and supply?
    6. What causes price to
    change?

    Markets and the
    Market Process

    P

    eople (and firms and nations) can get more
    if they specialize in certain activities and
    then trade with one another to acquire the
    goods and services they desire. But how are the specialized producers to get
    together or to know who specializes in what? We could allow the government to
    decide, or we could rely on first-come, first-served, or even simply luck. Typically
    it is the market mechanism—buyers and sellers interacting via prices—we rely on
    to ensure that gains from trade occur. To see why, consider the following situation
    and then carry out the exercise.

    Preview

    I. At a sightseeing point, reachable only after a strenuous hike, a firm has established a stand where bottled water is sold. The water, carried in by the employees
    of the firm, is sold to thirsty hikers in six-ounce bottles. The price is $1 per bottle.
    Typically only 100 bottles of the water are sold each day. On a particularly hot day,
    200 hikers want to buy at least one bottle of water. Indicate what you think of each
    of the following means of distributing the water to the hikers:
    1. Increasing the price until the quantity of water bottles hikers are willing and
    able to purchase exactly equals the number of water bottles available for sale
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable
    2. Selling the water for $1 per bottle on a first-come, first-served basis
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable
    3. Having the local authority (government) buy the water for $1 per bottle and
    distribute it according to its own judgment
    a. agree completely
    b. agree with slight reservation
    c. disagree

    26

    Part One / The Price System

    d. strongly disagree
    e. totally unacceptable
    4. Selling the water at $1 per bottle following a random selection procedure or
    lottery
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable
    The following is a similar situation but involves a different product.
    II. A physician has been providing medical services at a fee of $100 per patient
    and typically sees 30 patients per day. One day the flu bug has been so vicious that
    the number of patients attempting to visit the physician exceeds 60. Indicate what
    you think of each of the following means of distributing the physician’s services to
    the sick patients:
    1. Raising the price until the number of patients the doctor sees is exactly equal
    to those patients willing and able to pay the doctor’s fee
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable
    2. Selling the services at $100 per patient on a first-come, first-served basis
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable
    3. The local authority’s (government’s) paying the physician $100 per patient
    and choosing who is to receive the services according to its own judgment
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable
    4. Selling the physician’s services for $100 per patient following a random
    selection procedure or lottery
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable
    III. There are many more people needing a kidney transplant than there are kidneys available. Indicate what you think of each of the following ways of determining who gets the kidneys:
    1. Potential recipients’ buying the kidneys from donors, paying a price sufficient to equalize the number of kidneys needed and the number provided
    a. agree completely
    b. agree with slight reservation

    Chapter 2 / Markets and the Market Process

    27

    The fundamental economic
    problem is scarcity; that is, there
    is not enough to satisfy everyone.
    When a good or resource is
    scarce, there is a cost to acquiring it. The cost may be the price
    of the good or resource if the
    price is used as the allocating
    mechanism. The cost may be the
    time devoted to acquiring the
    good or resource when the price
    is not used as the allocation
    mechanism. In this case, people
    are spending hours in line just so
    they can obtain a couple of gallons of drinking water.

    c. disagree
    d. strongly disagree
    e. totally unacceptable
    2. Allocating the kidneys on a first-come, first-served basis
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable
    3. The government’s deciding who gets the kidneys
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable
    4. Providing the kidneys according to a random procedure such as a lottery
    a. agree completely
    b. agree with slight reservation
    c. disagree
    d. strongly disagree
    e. totally unacceptable ■

    ?
    1. How are goods and
    services allocated?

    28

    1. ALLOCATION MECHANISMS
    How did you respond to the alternative choices? You had the choice among four allocation mechanisms for the scarce goods and services: market; first-come, firstserved; government; and random. Did you notice that no matter which allocation
    mechanism is used, someone gets the good or service and someone doesn’t? With the
    market system, it is those who are least willing or able to pay who must do without.
    Under the first-come, first-served system, it is those who arrive later who do without.

    Part One / The Price System

    Under the government scheme, it is those not in favor or those who do not match up
    with the government’s rules who do without. And with a random procedure, it is
    those who do not have the lucky ticket or correct number who are left out.
    Since each allocation mechanism is in a sense unfair, how do we decide which
    to use? One way might be the incentives each creates. Suppose, just as a thought
    experiment, that everything—and we mean everything—in a society were allocated
    using a single allocation mechanism.
    With the first-come, first-served allocation scheme, the incentive is to be first.
    You would have no reason to improve the quality of your products or to increase
    the value of your resources. Your only incentive would be to be first. Supply would
    not increase. Why would anyone produce when all everyone wants is to be first?
    As a result, growth and standards of living would not rise. A society based on
    first-come, first-served would die a quick death.
    The government scheme provides an incentive either to be a member of government and thus help determine the allocation rules or to perform according to government dictates. There are no incentives to improve production and efficiency or
    quantities supplied and, therefore, no reason for the economy to grow. We’ve seen
    how this system fared with the collapse of the Soviet Union.
    The random allocation provides no incentives at all—simply hope that manna
    from heaven will fall on you.
    With the market system, the incentive is to acquire purchasing ability (to obtain
    income and wealth). This means you must provide goods that have high value to
    others or resources that have high value to producers. For example, you can enhance your worth as an employee by acquiring education or training, which increases the value of the resources you own.
    The market system also provides incentives for quantities of scarce goods to
    increase. In the case of the water stand in the first scenario, if the price of the water
    increases and the owner of the water stand is earning significant profits, others may
    carry or truck water to the top of the hill and sell it to thirsty hikers, and the amount
    of water available thus increases. In the case of the doctor in the second scenario,
    other doctors may think that opening an office near the first might be a way to earn
    more, and the amount of physician services available increases. Since the market
    system creates the incentive for the amount supplied to increase, economies grow
    and expand and standards of living improve. The market system also ensures that resources are allocated to where they are most highly valued. If the price of an item
    rises, consumers may switch over to another item or another good or service that can
    serve about the same purpose. When consumers switch, production of the alternative
    good rises and thus resources used in its production must increase as well. The resources then flow from the now lower-valued use to the new higher-valued use.

    1.a. Efficiency
    efficiency: the measure of
    how well an allocation system
    satisfies people’s wants and
    needs

    Economists evaluate the outcome of an economic system in terms of efficiency. Efficiency is a measure of how well a system satisfies people’s wants and needs. An
    efficient economic system exists when resources are allocated such that no one can
    be made better off without harming someone else. In contrast, an inefficient allocation is wasteful; better use of the available resources would make some people
    better off without harming anyone else.
    A system of markets and prices is generally the most efficient means of coordinating and organizing activities. Why? Because it takes fewer resources to work
    than any other system. Individuals offer to sell goods and services at various
    prices, and other individuals offer to buy goods and services at various prices.
    Without having anyone coordinating the buyers and sellers, the market determines a price for each traded good at which the quantities that people are willing
    and able to sell are equal to the quantities that people are willing and able to buy.
    This price informs buyers and sellers as to what they must give up to acquire a

    Chapter 2 / Markets and the Market Process

    29

    unit of the good (that is, their opportunity costs) and thereby lets them know
    whether their activities have value and in which activities they should specialize.
    Day in and day out, without any conscious central direction, the market system
    induces people to employ their talents and resources where these resources and talents have the highest value. People do not have to be fooled, cajoled, or forced to do
    their parts in a well-functioning market system, but instead they pursue their own
    objectives as they see fit. Workers, attempting to maximize their own individual happiness and well-being, select the training, careers, and jobs where their talents and
    energy are most valuable. Producers, pursuing only private profits, develop the
    goods and services on which consumers put the highest value and produce these
    goods and services at the lowest possible costs. Owners of resources, seeking only
    to increase their own wealth, deploy these assets in socially desirable ways.
    Does this behavior on the part of people lead to greed and selfishness? By saying
    that markets organize activities and allocate resources, are economists saying people
    should just do what they want irrespective of what their behavior does to others?
    The answer is no. Economists assume that people are self-interested, not meanspirited and selfish. Someone like Mother Teresa, who spent her life in the ghettos
    of India serving the poorest of the poor, would be described as self-interested. She
    gained satisfaction from sacrificing and helping others. Greed can do good if directed appropriately. The entrepreneur is greedy for success. The scientist is greedy
    for new knowledge. The artist is greedy for creativity. This type of greed can serve
    society well. Interacting in free markets enables these people to pursue self-interests
    without harming others. But what about someone who is greedy for someone else’s
    money or car and steals it? This is not a voluntary market transaction. This type of
    behavior is what economists call a violation of private property rights. When what
    people own is not secure and can be taken by others, a free market system does not
    work. When behavior that harms someone else occurs, then the victim’s private
    property rights have been violated. Economists say that voluntary exchange with

    30

    Part One / The Price System

    secure private property rights is essential for a free market. When these do not exist,
    something other than the market will be used to allocate scarce resources.

    1.b. Alternatives to Market Allocation
    The price, or market, system is the predominant allocation mechanism in most
    industrial societies today because it is generally the most efficient. Yet not all exchanges take place through the market system. Many medical services are provided on a first-come, first-served basis. Classes in schools are often allocated on
    a first-come, first-served basis. The use of highways or roadways is typically
    first-come, first-served. Governments allocate many goods: radio and television
    broadcast bands, land use (zoning), rights-of-way at intersections, and many
    others. Even luck—random allocation—plays a part in the allocation of some
    items such as concert tickets, lottery winnings, and other contest prizes. If the
    market system is such an efficient mechanism, why is it not universally relied
    on? One reason is that for some products people do not like the outcome of the
    market system. They don’t think it is fair, or they think some other way to allocate the scarce goods and services would be preferable. A second reason is that
    the market system may not be the most efficient allocation mechanism in some
    circumstances. A third reason is that in some circumstances, the market may simply not be able to function. We will talk about each of these after we have discussed how markets allocate scarce goods, services, and resources.

    R E C A P

    ?
    2. How does a market
    work?

    1. Allocation mechanisms are the means used to distribute scarce goods and resources. Common allocation mechanisms are first-come, first-served; government; random; and the market system.
    2. The outcome of an exchange system is evaluated on the basis of efficiency.
    An efficient allocation of resources is one in which resources are allocated so
    that no one can be made better off without harming someone else.
    3. The price or market system is relied on for most exchanges because it is
    generally the most efficient. It creates incentives that lead to growth and
    improvements in standards of living.

    2. HOW MARKETS FUNCTION
    When the Mazda Miata was introduced in the United States in 1990, the little sports
    roadster was an especially desired product in southern California. As shown in
    Figure 1, the suggested retail price was $13,996, the price at which it was selling in
    Detroit. In Los Angeles, the purchase price was nearly $25,000.
    Several entrepreneurs recognized the profit potential in the $10,000 price differential and sent hundreds of students to Detroit to pick up Miatas and drive them
    back to Los Angeles. Within a reasonably short time, the price differential between
    Detroit and Los Angeles was reduced. The increased sales in Detroit drove the
    price there up while the increased number of Miatas being sold in Los Angeles reduced the price there. The price differential continued to decline until it was less
    than the cost of shipping the cars from Detroit to Los Angeles. This story of the
    Mazda Miata illustrates how markets work to allocate scarce goods, services, and
    resources. A product is purchased where its price is low and sold where its price is
    high. As a result, resources devoted to that product flow to where they have the
    highest value. The same type of situation occurred with the introduction of the

    Chapter 2 / Markets and the Market Process

    31

    Arbitrage
    The Mazda Miata was initially
    selling for nearly $25,000 in
    Los Angeles and $14,000 in
    Detroit. People purchased the
    car in Detroit and sold it in
    Los Angeles, thereby driving
    the prices closer together.

    Price of the Mazda Miata (dollars)

    Figure 1

    25,000
    20,000
    15,000
    10,000
    5,000
    0

    Detroit

    Los Angeles

    Mini Cooper in 2001. The car was an especially hot item in California, so people
    purchased the car in Chicago or New York, where there was less demand, and had
    the cars shipped to California.
    Suppose an electronics firm is inefficient, its employees surly, and its products
    not displayed well. To attempt to earn a profit, the firm charges more than the efficiently run firm down the street. Where do customers go? Obviously, they seek out
    the best deal and go to the efficient firm. The more efficient store has to get more
    supplies, hire more employees, acquire more space, and so on. The inefficient store
    lays off employees and sells used equipment and supplies. In short, the resources
    flow from where they are not as highly valued to where they are more highly valued.
    The market process tends to ensure that the goods and services consumers
    want are provided at the lowest possible price, that resources are used where
    they are most highly valued, and that inefficient firms and inefficiency in
    general do not last.

    The BMW Mini Cooper hit the
    market in 2001. The demand
    far exceeded the number of
    cars available. Some dealers,
    notably in California, were
    charging premiums of as
    much as 30 percent above list
    price, while in other areas of
    the United States, a wait of
    nearly a year was required. As a
    result, cars were purchased in
    lower-priced locations and
    transported to California; and
    cars were purchased where
    available and shipped to
    locations where cars were not
    available.

    32

    Part One / The Price System

    Why does the market process work? For a very simple reason. People are looking for the best deal—the highest quality products at the lowest prices. So when an
    opportunity for a “best deal” arises, people respond to it by purchasing where the
    price is low and selling where the price is high.
    A market consists of demand (buyers) and supply (sellers). In the rest of this
    chapter we will look at the market process in more detail by examining demand,
    then supply, and then putting the two together.

    R E C A P

    1. A market need not be a specific location. A market exists when buyers and
    sellers interact to buy and sell a specific product.
    2. The market process refers to the buying and selling of a good and the resulting allocation of resources to their highest-valued uses.

    ?
    3. What is demand?

    demand: the amount of a
    product that people are willing
    and able to purchase at every
    possible price

    3. DEMAND
    The demand for a good or service is based on the behavior of the buyers of that
    good or service. Demand is a relationship between the price of the good or service
    and the quantity of that good or service people are willing and able to buy. That relationship is such a strong one that it is referred to as a law—the law of demand.
    3.a. The Law of Demand

    law of demand: an inverse
    relationship between price and
    quantity demanded

    The law of demand states that:
    1.
    2.
    3.
    4.

    the quantity of a well-defined good or service
    that people are willing and able to purchase
    during a particular period of time
    decreases as the price of that good or service rises and increases as the price
    falls
    5. everything else held constant.
    The first phrase ensures that we are referring to the same item, that we are not
    mixing different goods. A Rolex watch is different from a Timex watch; Polo brand
    golf shirts are different goods than generic brand golf shirts; Mercedes-Benz automobiles are different goods than Yugo automobiles.
    The second phrase indicates that people must not only want to purchase some
    good; they must also be able to purchase that good in order for their wants to be
    counted as part of demand. For example, Sue would love to buy a membership to
    the Paradise Valley Country Club, but because a membership costs $55,000, she is
    not able to purchase a membership. Though willing, she is not able. At a price of
    $5,000, however, she is willing and able to purchase a membership.
    The third phrase points out that the demand for any good is defined for a specific
    period of time. Without reference to a time period, a demand relationship would not
    make any sense. For instance, the statement that “at a price of $3 per Happy Meal,
    13 million Happy Meals are demanded” provides no useful information. Are the 13
    million meals sold in one week or one year? Think of demand as a rate of purchase
    at each possible price over a period of time—two per month, one per day, and so on.
    The fourth phrase points out that price and quantity demanded move in opposite
    directions; that is, as the price rises, the quantity demanded falls, and as the price
    falls, the quantity demanded rises.

    Chapter 2 / Markets and the Market Process

    33

    The final phrase, “everything else held constant,” ensures that things or events
    that affect demand other than price do not change. The demand for a good or service depends on the price of that good or service but also on income, tastes, prices
    of related goods and services, expectations, and the number of buyers. If any one of
    these changes, demand changes.

    3.b. The Demand Schedule
    demand schedule: a table
    listing the quantity demanded
    at each price

    A demand schedule is a table or list of the prices and the corresponding quantities
    demanded of a particular good or service. The table in Figure 2 is a demand schedule for DVD rentals (movies). It shows the number of DVDs that a consumer named
    Bob would be willing and able to rent at each price during the year, everything else
    held constant. As the rental price of the DVDs gets higher relative to the prices of
    other goods, Bob would be willing and able to rent fewer DVDs.
    At the high price of $5 per DVD, Bob indicates that he will rent only 10 DVDs
    during the year. At a price of $4 per DVD, Bob tells us that he will rent 20 DVDs
    during the year. As the price drops from $5 to $4 to $3 to $2 to $1, Bob is willing
    and able to rent more DVDs. At a price of $1, Bob would rent 50 DVDs during the
    year, nearly 1 per week.

    3.c. The Demand Curve
    demand curve: a graph
    showing the law of demand

    A demand curve is a graph of the demand schedule. The demand curve shown in Figure 2 is plotted from the information given in the demand schedule. Price is measured
    on the vertical axis, quantity per unit of time on the horizontal axis. Point A in Figure 2
    corresponds to combination A in the table: a price of $5 and 10 DVDs demanded. Similarly, points B, C, D, and E in Figure 2 represent the corresponding combinations in
    the table. The line connecting these points is Bob’s demand curve for DVDs.

    Figure 2
    Bob’s Demand Schedule and Demand Curve for DVDs

    Combination

    Price per DVD
    (constant-quality
    units)

    Quantity
    Demanded
    per Year
    (constantquality units)

    A

    $5

    10

    B

    4

    20

    C

    3

    30

    D

    2

    40

    E

    1

    50

    price–quantity combination of $5 per DVD and 10 DVDs is
    point A. The combination of $4 per DVD and 20 DVDs is
    point B. Each combination is plotted, and the points are
    connected to form the demand curve.

    5

    Price per DVD (dollars)

    The number of DVDs that Bob is willing and able to rent
    at each price during the year is listed in the table, or
    demand schedule. The demand curve is derived from
    the combinations given in the demand schedule. The

    A
    B

    4

    C

    3

    D

    2

    E

    1

    Demand
    0

    10

    20

    30

    40

    50

    60

    Quantity (number of DVDs)/year

    34

    Part One / The Price System

    3.d. From Individual Demand Curves to a Market Curve
    market demand: the sum of
    the individual demands

    Unless Bob is the only renter of the DVDs, his demand curve is not the total, or market demand, curve. Market demand is the sum of all individual demands. To derive
    the market demand curve, then, the individual demand curves of all consumers in the
    market must be added together. The table in Figure 3 lists the demand schedules of
    three individuals: Salman, Akira, and Elena. Because in this example the market consists only of Salman, Akira, and Elena, their individual demands are added together
    to derive the market demand. The market demand is the last column of the table.
    Salman’s, Akira’s, and Elena’s demand schedules are plotted as individual demand curves in Figure 3(a). In Figure 3(b) their individual demand curves have
    been added together to obtain the market demand curve. (Notice that we add in a
    horizontal direction; that is, we add quantities at each price, not the prices at each
    quantity.) At a price of $5, we add the quantity Salman would buy, 10, to the quantity Akira would buy, 5, to the quantity Elena would buy, 15, to get the market demand of 30. At a price of $4, we add the quantities each of the consumers is willing
    and able to buy to get the total quantity demanded of 48. At all prices, then, we add
    the quantities demanded by each individual consumer to get the total, or market
    quantity, demanded.

    Now You Try It
    Using the demand schedule for two individuals, Andrea and Rene, compute the market
    demand if these two are the only consumers.
    10

    8

    6

    4

    Quantity Andrea is willing
    and able to purchase

    Price

    5

    7

    8

    9

    Quantity Rene is willing
    and able to purchase

    3

    4

    6

    7

    3.e. Changes in Demand and Changes in Quantity Demanded
    quantity demanded: the
    amount of a product that
    people are willing and able to
    purchase at a specific price

    determinants of demand:
    things that influence demand
    other than the price

    Economists distinguish between the terms demand and quantity demanded. When
    they refer to the quantity demanded, they are talking about the amount of a product
    that people are willing and able to purchase at a specific price. When they refer to
    demand, they are talking about the amount that people would be willing and able to
    purchase at every possible price. Thus, the statement that “the demand for U.S.
    white wine rose after a 300 percent tariff was applied to French white wine” means
    that at each price for U.S. white wine, more people were willing and able to purchase U.S. white wine than before the tariff. And the statement that “the quantity
    demanded of white wine fell as the price of white wine rose” means that people were
    willing and able to purchase less white wine because the price of the wine rose.
    When the price of a good or service is the only factor that changes, the quantity
    demanded changes, but the demand curve does not. Instead, as the price of the
    DVDs is decreased (increased), everything else held constant, the quantity that
    people are willing and able to purchase increases (decreases). This change is
    merely a movement from one point on the demand curve to another point on the
    same demand curve, not a shift of the demand curve.
    The demand curve shifts when any one of the determinants of demand changes:
    income, tastes, prices of related goods, expectations, or the number of buyers. Let’s
    consider how each of these determinants of demand affects the demand curve.

    Chapter 2 / Markets and the Market Process

    35

    Figure 3

    Quantities Demanded per Year by

    The Market Demand Schedule and Curve
    for DVDs
    The market is defined as consisting of three individuals:
    Salman, Akira, and Elena. Their demand schedules are
    listed in the table and plotted as the individual demand
    curves shown in Figure 3(a). By adding the quantities that
    each demands at every price, we obtain the market demand curve shown in Figure 3(b). At a price of $1 we add
    Salman’s quantity demanded of 50 to Akira’s quantity demanded of 25 to Elena’s quantity demanded of 27 to obtain the market quantity demanded of 102. At a price of
    $2 we add Salman’s 40 to Akira’s 20 to Elena’s 24 to obtain the market quantity demanded of 84. To obtain the
    market demand curve, for every price we sum the quantities demanded by each market participant.

    Market
    Demand

    Price
    per DVD

    Salman

    $5

    10

    4

    20

    10

    18

    48

    3

    30

    15

    21

    66

    2

    40

    20

    24

    84

    1

    50

    25

    27

    102

    Akira

    +

    5

    Elena
    +

    15

    =

    30

    (a) Individual Demand Curves

    Salman

    5

    4
    3
    2
    1

    20

    30

    40

    4
    3
    2
    1

    D
    10

    Price per DVD (dollars)

    5

    Price per DVD (dollars)

    Price per DVD (dollars)

    5

    0

    Elena

    Akira

    50

    20

    10

    3
    2
    1

    D

    0

    Quantity (number of DVDs)
    /year

    4

    30

    40

    Quantity (number of DVDs)
    /year

    0

    D
    10

    20

    30

    40

    Quantity (number of DVDs)
    /year

    (b) Market Demand Curve

    Price per DVD (dollars)

    5
    4
    3
    2

    Salman

    Akira

    Elena

    1

    Market Demand
    0

    10

    20

    30

    40

    50

    60

    70

    80

    90

    100

    110

    Quantity (number of DVDs)/year

    36

    Part One / The Price System

    normal goods: as income
    rises, quantity demanded rises
    inferior goods: as income
    rises, quantity demanded falls

    substitute goods: items that
    can be used in place of each
    other; as the price of one rises,
    demand for the other rises

    complementary goods: items
    that are used together; as the
    price of one rises, demand for
    the other falls

    Income The demand for any good or service depends on income. Typically, the
    higher someone’s income is, the more of a particular good or service that person
    will buy. These are called normal goods. There are some goods that people buy
    less of when their income rises. These are called inferior goods.
    Tastes The demand for any good or service depends on individuals’ tastes and
    preferences, and tastes can change. When they do change, demand changes. For example, in the 1980s, people ate lots of pasta and bread because they were supposed
    to help sustain energy over a long period or during strenuous exercise. By 2004,
    however, the Atkins diet had changed people’s tastes, and as a result, the demand
    for carbohydrate foods—pasta, breads, potatoes, and even Krispy Kremes—
    declined. Tastes changed, so demand changed. Then they changed again. By 2006,
    people were consuming carbs again.
    Prices of Related Goods and Services Goods and services may be related in
    two ways. If buyers can use either of two or more goods for the same purpose, then
    these are called substitute goods. Substitute goods can be used for each other, so
    that as the price of one rises, the demand for the other rises. Bread and crackers,
    BMWs and Acuras, DVDs and theater movies, universities and community colleges, Coca-Cola and Pepsi are, more or less, substitutes.
    If two or more goods or services are used together so that as the price of one
    rises, demand for the other falls, they are called complementary goods. Bread
    and margarine, beer and peanuts, cameras and film, shoes and socks, CDs and CD
    players, DVDs and DVD players are examples of complementary goods.
    Expectations Expectations about future events can have an effect on demand
    today. People make purchases today because they expect their income level to be
    a certain amount in the future, or they expect prices to be different in the future.
    Number of Buyers Market demand consists of the sum of the demands of all individuals. The more individuals there are with income to spend, the greater the market
    demand is likely to be. For example, the populations of Florida and Arizona are much
    larger during the winter than they are during the summer. The demand for any particular good or service in Arizona and Florida rises (the demand curve shifts to the right)
    during the winter and falls (the demand curve shifts to the left) during the summer.

    R E C A P

    1. According to the law of demand, as the price of any good or service rises
    (falls), the quantity demanded of that good or service falls (rises) during a
    specific period of time, everything else held constant.
    2. A demand schedule is a listing of the quantity demanded at each price.
    3. The demand curve is a downward-sloping line plotted using the values of the
    demand schedule.
    4. Market demand is the sum of all individual demands.
    5. Demand changes when one of the determinants of demand changes. A demand change is a shift of the demand curve.
    6. The quantity demanded changes when the price of the good or service
    changes. This is a change from one point on the demand curve to another
    point on the same demand curve.
    7. The determinants of demand are income, tastes, prices of related goods and
    services, expectations, and number of buyers.

    Chapter 2 / Markets and the Market Process

    37

    ?
    4. What is supply?

    supply: the quantities
    suppliers are willing and able
    to supply at each price
    law of supply: as the price
    rises, the quantity supplied
    rises and vice versa

    determinants of supply: those
    factors that affect supply other
    than price

    4. SUPPLY
    The supply of a good or service is derived from the behavior of the producers and
    sellers of that good or service. Supply is a relationship between the price of the
    good or service and the quantity of that good or service people or firms are willing
    and able to supply. That relationship is such a strong one that it is referred to as a
    law—the law of supply.

    4.a. The Law of Supply
    Like the law of demand, the law of supply also consists of five phrases:
    1.
    2.
    3.
    4.

    the quantity of a well-defined good or service
    that producers are willing and able to offer for sale
    during a particular period of time
    increases as the price of the good or service increases and decreases as the
    price decreases
    5. everything else held constant.
    The first phrase is the same as the first phrase in the law of demand. The second
    phrase indicates that producers must not only want to offer the product for sale
    but must also be able to offer the product. The third phrase points out that the quantities producers will offer for sale depend on the period of time being considered.
    The fourth phrase points out that more will be supplied at higher than at lower
    prices. The final phrase ensures that the determinants of supply do not change. The
    determinants of supply are those factors that influence the willingness and ability
    of producers to offer their goods and services for sale—the prices of resources used
    to produce the product, technology and productivity, expectations of producers,
    number of producers in the market, and prices of related goods and services. If any
    one of these should change, supply changes.

    4.b. The Supply Schedule and Supply Curve
    supply schedule: a list of
    prices and corresponding
    quantities supplied

    supply curve: a plot of the
    supply schedule

    A supply schedule is a table or list of the prices and the corresponding quantities
    supplied of a good or service. The table in Figure 4 presents MGA’s supply schedule
    for DVDs. The schedule lists the quantities that MGA is willing and able to supply
    at each price, everything else held constant. As the price increases, MGA is willing
    and able to offer more DVDs for sale.
    A supply curve is a graph of the supply schedule. Figure 4 shows MGA’s supply
    curve for DVDs. The price and quantity combinations given in the supply schedule
    correspond to the points on the curve. For instance, combination A in the table corresponds to point A on the curve; combination B in the table to point B on the curve,
    and so on, for each price–quantity combination.

    4.c. From Individual Supply Curves to the Market Supply
    To derive market supply, the quantities that each producer supplies at each price are
    added together, just as the quantities demanded by each consumer are added together to get market demand. The table in Figure 5 lists the supply schedules of
    three DVD stores: MGA, Motown, and Blockmaster. For our example, we assume
    that these three are the only DVD stores offering DVDs. (We are also assuming that
    the brand names are not associated with quality or any other differences.)
    The supply schedule of each producer is plotted in Figure 5(a). Then in Figure 5(b)
    the individual supply curves have been added together to obtain the market supply
    curve. At a price of $5, the quantity supplied by MGA is 60, the quantity supplied
    by Motown is 30, and the quantity supplied by Blockmaster is 12. This means a total quantity supplied in the market of 102. At a price of $4, the quantities supplied
    38

    Part One / The Price System

    Figure 4
    The quantity that MGA is willing and able to offer for sale
    at each price is listed in the supply schedule and shown
    on the supply curve. At point A, the price is $5 per DVD,

    Combination

    Price per DVD
    (constantquality
    units)

    Quantity
    Supplied
    per Year
    (constantquality units)

    A

    $5

    60

    B

    4

    50

    C

    3

    40

    D

    2

    30

    E

    1

    20

    and the quantity supplied is 60 DVDs. The combination of
    $4 per DVD and 50 DVDs is point B. Each price-quantity
    combination is plotted, and the points are connected to
    form the supply curve.

    A

    5

    Price per DVD (dollars)

    MGA’s Supply Schedule and Supply Curve for DVDs

    B

    4

    C

    3

    D

    2

    E

    1

    0

    Supply

    10

    20

    30

    40

    50

    60

    Quantity (number of DVDs)/time period

    are 50 by MGA, 25 by Motown, and 9 by Blockmaster for a total market quantity
    supplied of 84. The market supply schedule is the last column in the table. The plot
    of the price and quantity combinations listed in this column is the market supply
    curve.

    4.d. Changes in Supply and Changes in Quantity Supplied
    When we draw the supply curve, we allow only the price and quantity supplied of
    the good or service we are discussing to change. Everything else that might affect
    supply is assumed not to change. If any of the determinants of supply—the prices
    of resources used to produce the product, technology and productivity, expectations
    of producers, number of producers in the market, and prices of related goods and
    services—changes, the supply schedule changes and the supply curve shifts.
    Prices of Resources If labor costs—one of the resources used to produce
    DVDs—rise, higher prices will be necessary to induce each store to offer as many
    DVDs as it did before the cost of the resource rose. Conversely, if resource prices decline, then supply of DVDs would increase.
    Technology and Productivity If resources are used more efficiently in the production of a good or service, more of that good or service can be supplied for the
    same cost; supply will rise.
    Expectations of Producers Sellers may choose to alter the quantity offered for
    sale today because of a change in expectations regarding future prices.
    Number of Producers When more producers decide to offer a good or service
    for sale, the market supply increases.

    Chapter 2 / Markets and the Market Process

    39

    Figure 5

    Quantities Supplied per Year by

    The Market Supply Schedule and Curve for DVDs
    The market supply is derived by summing the
    quantities that each producer is willing and able to
    offer for sale at each price. In this example, there
    are three producers: MGA, Motown, and Blockmaster. The supply schedules of each are listed in the
    table and plotted as the individual supply curves in
    part (a). By adding the quantities supplied at each
    price, we obtain the market supply curve shown in
    part (b). For instance, at a price of $5, MGA offers
    60 units, Motown 30 units, and Blockmaster 12
    units, for a market supply quantity of 102. The market supply curve reflects the quantities that all producers are able and willing to supply at each price.

    Market
    Supply

    Price
    per DVD

    MGA

    $5

    60

    4

    50

    25

    9

    84

    3

    40

    20

    6

    66

    2

    30

    15

    3

    48

    1

    20

    10

    0

    30

    Motown
    +

    30

    Blockmaster

    +

    =

    12

    102

    (a) Individual Supply Curves

    MGA

    Motown
    S

    3
    2
    1

    4
    3
    2
    1

    10

    20

    30

    40

    50

    60

    4
    3
    2
    1

    0

    Quantity (number of DVDs)
    /year

    S

    5

    Price per DVD (dollars)

    4

    0

    S

    5

    Price per DVD (dollars)

    Price per DVD (dollars)

    5

    Blockmaster

    10

    20

    30

    40

    Quantity (number of DVDs)
    /year

    0

    10

    20

    30

    40

    Quantity (number of DVDs)
    /year

    (b) Market Supply Curve

    MGA

    Price per DVD (dollars)

    5

    Motown

    Blockmaster
    Market Supply

    4
    3
    2
    1

    0

    10

    20

    30

    40

    50

    60

    70

    80

    90

    100

    110

    Quantity (number of DVDs)/year

    40

    Part One / The Price System

    Prices of Related Goods or Services (In Production) The opportunity cost of
    producing and selling any good or service is the forgone opportunity to produce
    any other good or service. If the price of an alternative good changes, then the opportunity cost of producing a particular good changes. This could cause the supply
    curve to change.

    R E C A P

    1. According to the law of supply, the quantity supplied of any good or service
    is directly related to the price of the good or service, during a specific period
    of time, everything else held constant.
    2. Market supply is found by adding together the quantities supplied at each
    price by every producer in the market.
    3. Supply changes if prices of relevant resources change, if technology or productivity changes, if producers’ expectations change, if the number of producers changes, or if prices of related goods and services change.
    4. Changes in supply are reflected in shifts of the supply curve. Changes in the
    quantity supplied are reflected in movements along the supply curve.

    5. EQUILIBRIUM: PUTTING DEMAND
    AND SUPPLY TOGETHER

    equilibrium: the price and
    quantity at which quantity
    demanded equals quantity
    supplied

    ?
    5. How is price determined
    by demand and supply?
    surplus: the quantity demanded
    is less than the quantity supplied

    shortage: the quantity
    demanded is greater than the
    quantity supplied

    The demand curve shows the quantity of a good or service that buyers are willing
    and able to purchase at each price. The supply curve shows the quantity that producers are willing and able to offer for sale at each price. Only where the two
    curves intersect is the quantity supplied equal to the quantity demanded. This intersection is the point of equilibrium.

    5.a. Determination of Equilibrium
    Figure 6 brings together the market demand and market supply curves for DVDs.
    The supply and demand schedules are listed in the table, and the curves are plotted
    in the graph in Figure 6. Notice that the curves intersect at only one point, labeled
    e, a price of $3 and a quantity of 66. The intersection point is the equilibrium
    price, the only price at which the quantity demanded and quantity supplied are the
    same.
    Whenever the price is greater than the equilibrium price, a surplus arises. For
    example, at $4, the quantity of DVDs demanded is 48, and the quantity supplied is
    84. Thus, at $4 per DVD there is a surplus of 36 DVDs; that is, 36 DVDs are not
    purchased. Conversely, whenever the price is below the equilibrium price, the
    quantity demanded is greater than the quantity supplied, and there is a shortage.
    For instance, if the price is $2 per DVD, consumers will want and be able to pay for
    more DVDs than are available. As shown in the table in Figure 6, the quantity demanded at a price of $2 is 84, but the quantity supplied is only 48. There is a shortage of 36 DVDs at the price of $2.
    Neither a surplus nor a shortage exists for long if the price of the product is free
    to change. Producers who are stuck with DVDs sitting on the shelves getting out of
    date will lower the price and reduce the quantities they are offering for sale in order
    to eliminate a surplus. Conversely, producers whose shelves are empty as consumers demand DVDs will acquire more DVDs and raise the price to eliminate
    the shortage. Surpluses lead to decreases in the price and the quantity supplied and

    Chapter 2 / Markets and the Market Process

    41

    Figure 6
    Equilibrium

    Quantity
    Supplied
    per Year

    Status

    $5

    30

    102

    Surplus of 72

    4

    48

    84

    Surplus of 36

    3

    66

    66

    Equilibrium

    2

    84

    48

    Shortage of 36

    1

    102

    30

    Shortage of 72

    S

    5

    Price per DVD (dollars)

    Equilibrium is established at the point
    where the quantity that suppliers are
    willing and able to offer for sale is the
    same as the quantity that buyers are
    willing and able to purchase. Here, equilibrium occurs at the price of $3 per DVD
    and the quantity of 66 DVDs. It is shown
    as point e at the intersection of the demand and supply curves. At prices above
    $3, the quantity supplied is greater than
    the quantity demanded, and the result is
    a surplus. At prices below $3, the quantity supplied is less than the quantity demanded, and the result is a shortage.
    The area shaded yellow shows all prices
    at which there is a surplus—where quantity supplied is greater than the quantity
    demanded. The surplus is measured in a
    horizontal direction at each price. The
    area shaded blue represents all prices at
    which a shortage exists—where the
    quantity demanded is greater than the
    quantity supplied. The shortage is measured in a horizontal direction at each
    price.

    Quantity
    Demanded
    per Year

    Price
    per DVD

    Surplus of 36 DVDs
    4

    48

    84

    e

    3

    48

    2

    84

    Shortage of 36 DVDs
    1

    0

    D
    10

    20

    30

    40

    50

    60 66 70

    80

    90

    100

    110

    Quantity (number of DVDs)/time period

    increases in the quantity demanded. Shortages lead to increases in the price and the
    quantity supplied and decreases in the quantity demanded.
    Sometimes people confuse scarcity with shortage. Scarcity occurs for almost
    everything. It refers to the idea that something is not free; there is not enough of
    that item to satisfy everyone who would want it if it cost nothing. Shortage refers to
    a specific price; there is not enough of the item available at a specific price to satisfy everyone who would be willing and able to purchase the item at that specific
    price. A shortage exists only if more is demanded than supplied at a specific price
    whereas scarcity exists if more is wanted than is available at a zero price. A shortage is eliminated by the price being driven up. Scarcity always exists.

    ?
    6. What causes price to
    change?

    42

    5.b. Changes in the Equilibrium Price: Demand Shifts
    Once a market is in equilibrium, there is no incentive for producers or consumers to
    move away from it. An equilibrium price changes only when demand or supply
    changes, that is, when the determinants of demand or the determinants of supply
    change.
    Let’s consider a change in demand and what it means for the equilibrium price.
    Suppose that experiments on rats show that watching DVDs causes brain damage.
    As a result, a large segment of the human population decides not to watch DVDs.
    Stores find that the demand for videos decreases, as shown in Figure 7 by a leftward shift of the demand curve, from curve D1 to curve D2.
    Part One / The Price System

    Figure 7
    The Effects of a Shift of the Demand
    Curve
    Price per DVD (dollars)

    The initial equilibrium price ($3 per
    DVD) and quantity (66 DVDs) are established at point e1, where the initial
    demand and supply curves intersect.
    A change in the taste for DVDs causes
    demand to decrease, and the demand
    curve shifts to the left. At $3 per DVD,
    the initial quantity supplied, 66 DVDs,
    is now greater than the quantity demanded, 48 DVDs. The surplus of 18
    DVDs causes producers to reduce production and lower the price. The market reaches a new equilibrium at
    point e2, $2.50 per DVD and 57 DVDs.

    S

    5

    Surplus of
    18 DVDs

    4

    e1

    3

    e2

    2.50
    2
    1

    0

    D2
    10

    20

    30

    40

    50
    60
    48
    57

    70
    66

    80

    90

    D1
    100

    110

    Quantity (number of DVDs)/year

    Now You Try It
    Using the information provided below, find the equilibrium price and quantity. Then show
    the equilibrium on a graph of demand and supply curves.
    Price
    Quantity Demanded
    Quantity Supplied

    $1200

    $1000

    $800

    400

    800

    1200

    1000

    800

    600

    Once the demand curve has shifted, the original equilibrium price of $3 per
    DVD at point e1 is no longer the equilibrium. At a price of $3, the quantity supplied
    is still 66, but the quantity demanded has declined to 48 (look at the demand curve
    D2 at a price of $3). There is, therefore, a surplus of 18 DVDs at the price of $3.
    With a surplus comes downward pressure on the price. This downward pressure
    occurs because stores offer fewer DVDs and reduce the price in an attempt to sell
    the DVDs sitting on the shelves. Producers continue reducing the price and the
    quantity available until consumers purchase all copies of the DVDs that the sellers

    Now You Try It
    Using the following data, determine the equilibrium price and quantity. Then, using
    Quantity Supplied (2), find the equilibrium price and quantity. Use a diagram to illustrate
    what occurred.
    Price

    $10

    $9

    $8

    $7

    $6

    $5

    $4

    $3

    $2

    $1

    Quantity Supplied

    200

    180

    160

    140

    120

    100

    80

    60

    40

    20

    Quantity Demanded

    10

    50

    85

    100

    120

    140

    160

    170

    175

    178

    Quantity Supplied (2)

    240

    220

    200

    180

    160

    140

    120

    100

    80

    60

    Chapter 2 / Markets and the Market Process

    43

    have available, or until a new equilibrium is established. That new equilibrium occurs at point e2 with a price of $2.50 and a quantity of 57.
    The decrease in demand is represented by the leftward shift of the demand
    curve. A decrease in demand results in a lower equilibrium price and a lower equilibrium quantity as long as there is no change in supply. Conversely, an increase in
    demand would be represented as a rightward shift of the demand curve and would
    result in a higher equilibrium price and a higher equilibrium quantity as long as
    there is no change in supply.

    5.c. Changes in the Equilibrium Price: Supply Shifts
    The equilibrium price and quantity may be altered by a change in supply as well.
    For example, petroleum is a key ingredient in DVDs. Suppose the quantity of oil
    available is reduced by 40 percent, causing the price of oil to rise. Every DVD
    manufacturer has to pay more for oil, which means that the stores must pay more
    for each DVD. The stores must receive a higher rental price in order to cover
    their higher costs. This is represented by a leftward shift of the supply curve in
    Figure 8.
    The leftward shift of the supply curve, from curve S1 to curve S2, leads to a new
    equilibrium price and quantity. At the original equilibrium price of $3 at point e1,
    66 DVDs are supplied. After the shift in the supply curve, 48 DVDs are offered for
    at a price of $3 apiece, and there is a shortage of 18 DVDs. The shortage puts upward pressure on price. As the price rises, consumers decrease the quantities that
    they are willing and able to buy, and sellers increase the quantities that they are
    willing and able to supply. Eventually, a new equilibrium price and quantity is established at $3.50 and 57 DVDs at point e2.
    The decrease in supply is represented by the leftward shift of the supply curve.
    A decrease in supply with no change in demand results in a higher price and a
    lower quantity. Conversely, an increase in supply would be represented as a rightward shift of the supply curve. An increase in supply with no change in demand
    would result in a lower price and a higher quantity.

    Figure 8
    The Effects of a Shift of the Supply
    Curve

    44

    Price per DVD (dollars)

    The initial equilibrium price and quantity are $3 and 66 units, at point e1.
    When the price of labor increases,
    suppliers are willing and able to offer
    fewer DVDs for rent at each price. The
    result is a leftward (upward) shift of
    the supply curve, from S1 to S2. At the
    old price of $3, the quantity demanded is still 66, but the quantity
    supplied falls to 48. The shortage is
    18 DVDs. The shortage causes suppliers to raise the rental price and offer
    fewer DVDs for sale. The new equilibrium e2, the intersection between
    curves S2 and D, is $3.50 per DVD and
    57 DVDs.

    S2

    Shortage of
    18 DVDs

    5
    4

    S1

    e2

    3.50

    e1

    3
    2
    1

    0

    D
    10

    20

    30

    40

    48

    50

    60
    70
    57
    66

    80

    90

    100

    110

    Quantity (number of DVDs)/year

    Part One / The Price System

    R E C A P

    1. Equilibrium occurs when the quantity demanded and the quantity supplied
    are equal: it is the price-quantity combination where the demand and supply
    curves intersect.
    2. A price that is above the equilibrium price creates a surplus. Producers are
    willing and able to offer more for sale than buyers are willing and able to
    purchase.
    3. A price that is below the equilibrium price leads to a shortage. Buyers are
    willing and able to purchase more than producers are willing and able to offer for sale.
    4. When demand changes, price and quantity change in the same direction.
    Both rise as demand increases and both fall as demand decreases.
    5. When supply changes, price and quantity change but not in the same direction. When supply increases, price falls and quantity rises. When supply decreases, price rises and quantity falls.

    SUMMARY
    ?

    1.

    2.
    3.

    4.

    ?

    5.

    ?

    6.
    7.
    8.

    9.

    prices of related goods and services, expectations,
    or number of buyers change. A demand change is
    illustrated as a shift of the demand curve.

    How are goods and services allocated?

    The allocation of scarce goods, services, and resources can be carried out in any number of ways.
    The market mechanism is one possible allocation
    mechanism.
    The market mechanism is the most efficient allocation
    mechanism in most instances.
    There are cases in which the market mechanism is not
    used because people do not like the result of the market allocation.
    There are cases in which the market mechanism is
    not used because the market mechanism is not the
    most efficient.
    How does a market process work?

    The market process refers to the interaction between
    buyers and sellers and how the market goes about allocating scarce resources.
    What is demand?

    Demand is the quantities that buyers are willing and
    able to buy at alternative prices.
    The quantity demanded is the amount buyers are willing and able to buy at a specific price.
    The law of demand states that as the price of a
    well-defined commodity rises (falls), the quantity demanded during a given period of time will fall (rise),
    everything else held constant.
    Demand will change when one of the determinants
    of demand changes, that is, when income, tastes,

    Chapter 2 / Markets and the Market Process

    ?

    What is supply?

    10. Supply is the quantities that sellers will offer for sale
    at alternative prices.
    11. The quantity supplied is the amount sellers offer for
    sale at one price.
    12. The law of supply states that as the price of a welldefined commodity rises (falls), the quantity supplied
    during a given period of time will rise (fall), everything else held constant.
    13. Supply changes when one of the determinants of supply changes, that is, when prices of resources, technology and productivity, expectations of producers,
    number of producers, or prices of related goods or services (in production) change. A supply change is illustrated as a shift of the supply curve.
    ?

    How is price determined by demand and supply?

    14. Equilibrium is the price at which the quantity buyers
    are willing and able to buy equals the quantity sellers
    are willing and able to sell.
    15. A price that is higher than equilibrium means that
    buyers are willing and able to buy less than sellers are
    willing and able to supply. This will force sellers to
    reduce the price.
    16. A price that is lower than equilibrium means that buyers are willing and able to buy more than sellers are
    willing and able to supply. This will force sellers to
    raise the price.

    45

    17. Together, demand and supply determine the equilibrium price and quantity.
    ?

    19. A change in demand or a change in supply (a shift of
    either curve) will cause the equilibrium price and
    quantity to change.

    What causes price to change?

    18. A price that is above equilibrium creates a surplus,
    which leads to a lower price. A price that is below
    equilibrium creates a shortage, which leads to a higher
    price.

    EXERCISES
    1.

    Illustrate each of the following events using a demand
    and supply diagram for bananas.
    a. Reports surface that imported bananas are infected
    with a deadly virus.
    b. Consumers’ incomes drop.
    c. The price of bananas rises.
    d. The price of oranges falls.
    e. Consumers expect the price of bananas to decrease
    in the future.
    Answer true or false, and if the statement is false,
    change it to make it true. Illustrate your answers on a
    demand and supply graph.
    a. An increase in demand is represented by a movement up the demand curve.
    b. An increase in supply is represented by a movement up the supply curve.
    c. An increase in demand without any changes in
    supply will cause the price to rise.
    d. An increase in supply without any changes in demand will cause the price to rise.
    Using the following schedule, define the equilibrium
    price and quantity. Plot the demand and supply curves
    and show the equilibrium price and quantity.

    2.

    3.

    Quantity
    Demanded

    Quantity
    Supplied

    $1

    500

    100

    2

    400

    120

    3

    350

    150

    4

    320

    200

    5

    300

    300

    6

    275

    410

    7

    260

    500

    8

    230

    650

    9

    200

    800

    10

    150

    975

    Price

    46

    4.

    5.

    A severe drought in California has resulted in a nearly
    30 percent reduction in the quantity of citrus grown
    and produced there. Explain what effect this event
    might have on the Florida citrus market.
    The prices of the Ralph Lauren Polo line of clothing
    are considerably higher than comparable quality lines.
    Yet it sells more than a J.C. Penney brand line of
    clothing. Does this violate the law of demand?

    6.

    In December, the price of Christmas trees rises, and
    the quantity of trees sold rises. Is this a violation of
    the law of demand?

    7.

    Evaluate the following statement: “The demand
    for U.S. oranges has increased because the quantity of
    U.S. oranges demanded in Japan has risen.”

    8.

    The federal government requires that all foods display
    information about fat content and other ingredients
    on food packages. The displays have to be verified by
    independent laboratories. The price of an evaluation
    of a food product could run as much as $20,000. What
    impact do you think this law will have on the market
    for meat?

    9.

    Draw a downward-sloping demand curve and an
    upward-sloping supply curve for orange juice. Show
    what happens in each of the following cases:
    a. A freeze in Florida kills 30 percent of the oranges.
    b. A technological breakthrough has enabled Idaho to
    grow oranges.
    c. The supply of oranges from Mexico has been
    banned. The Mexican oranges accounted for about
    15 percent of the market.

    10. Explain what it means when the supply of television
    sets rises. Explain what it means when the quantity
    supplied of television sets rises. Explain how the price
    of television sets could rise, and yet the supply of television sets not change.

    Part One / The Price System

    Internet
    Exercise

    One of the most exciting changes in markets in the last decade has been the emergence of Internet auction markets. Use the Internet to explore this online venue for
    exchange.
    Go to the Boyes/Melvin, Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise link
    for Chapter 2. Now answer the questions that appear on the Boyes/Melvin website.

    Chapter 2 / Markets and the Market Process

    47

    Study Guide for Chapter 2
    Key Term Match

    Quick-Check Quiz

    Match each term with its correct definition by placing
    the appropriate letter next to the corresponding number.

    1

    Which of the following would not cause a decrease in
    the demand for bananas?
    ■ a. Reports surface that imported bananas are
    infected with a deadly virus.
    ■ b. Consumers’ incomes drop.
    ■ c. The price of bananas rises.
    ■ d. A deadly virus kills monkeys in zoos across the
    United States.
    ■ e. Consumers expect the price of bananas to
    decrease in the future.

    2

    Which of the following would cause an increase in the
    demand for eggs?
    ■ a. The price of eggs drops.
    ■ b. The price of bacon rises.
    ■ c. A government report indicates that eating eggs
    three times a week increases the chances of
    having a heart attack.
    ■ d. A decrease in the cost of chicken feed makes
    eggs less costly to produce.
    ■ e. None of the above would increase the demand
    for eggs.

    3

    If the price of barley, an ingredient in beer, increases,
    ■ a. the demand for beer will increase.
    ■ b. the demand for beer will not change.
    ■ c. the demand for beer will decrease.
    ■ d. the quantity of beer demanded will increase.
    ■ e. Both a and d are correct.

    4

    A freeze in Peru causes the price of coffee to skyrocket. Which of the following will happen?
    ■ a. The demand for coffee will increase, and the demand for tea will increase.
    ■ b. The demand for coffee will increase, and the
    quantity of tea demanded will increase.
    ■ c. The quantity of coffee demanded will increase,
    and the demand for tea will increase.
    ■ d. The quantity of coffee demanded will increase,
    and the quantity of tea demanded will
    increase.
    ■ e. The quantity of coffee demanded will decrease,
    and the demand for tea will increase.

    5

    Japanese producers of a type of microchip offered
    such low prices that U.S. producers of the chip were
    driven out of business. As the number of producers
    decreased,
    ■ a. the market supply of microchips increased—
    that is, the supply curve shifted to the right.

    A.
    B.
    C.
    D.
    E.
    F.
    G.
    H.
    I.
    J.

    efficiency
    demand
    law of demand
    demand schedule
    demand curve
    market demand
    quantity demanded
    determinants of demand
    substitute goods
    complementary goods

    K. supply
    L. law of supply
    M. determinants of
    supply
    N. supply schedule
    O. supply curve
    P. equilibrium
    Q. surplus
    R. shortage

    1. a graph showing the law of demand
    2. items that can be used in place of each other;
    as the price of one rises, demand for the other
    rises
    3. the quantities suppliers are willing and able to
    supply at each price
    4. a plot of the supply schedule
    5. a relationship between the price of a good or service and the quantity of that good or service people are willing and able to buy
    6. the price and quantity at which demand equals
    supply
    7. the quantity of a well-defined good or service
    that people are willing and able to purchase
    during a particular period of time decreases as
    the price of that good or service rises and increases as the price falls, everything else held
    constant
    8. as the price rises, the quantity supplied rises, and
    vice versa
    9. things that influence demand other than price
    10. a list of prices and corresponding quantities
    supplied
    11. items that are used together; as the price of one
    rises, demand for the other falls
    12. when the quantity demanded is less than the quantity supplied
    13. a table listing the quantity demanded at each
    price
    14. the sum of individual demands
    15. when the quantity demanded is greater than the
    quantity supplied
    16. factors other than price that affect supply
    17. a measure of how well an economic system satisfies people’s wants and needs
    18. the amount of a product that people are willing
    and able to purchase at a specific price
    48

    Part One / The Price System

    ■ b. the market supply of microchips increased—
    that is, the supply curve shifted to the left.
    ■ c. the market supply of microchips decreased—
    that is, the supply curve shifted to the right.
    ■ d. the market supply of microchips decreased—
    that is, the supply curve shifted to the left.
    ■ e. there was no change in the supply of microchips.
    (This event is represented by a movement from
    one point to another on the same supply curve.)
    6

    7

    8

    9

    Suppose that automakers expect car prices to be lower
    in the future. What will happen now?
    ■ a. Supply will increase.
    ■ b. Supply will decrease.
    ■ c. Supply will not change.
    ■ d. Demand will increase.
    ■ e. Demand will decrease.
    Medical research from South Africa indicates that vitamin A may be useful in treating measles. If the
    research can be substantiated, the
    ■ a. supply of vitamin A will increase, causing equilibrium price and quantity to increase.
    ■ b. supply of vitamin A will increase, causing equilibrium price to fall and quantity to increase.
    ■ c. demand for vitamin A will increase, causing
    equilibrium price and quantity to increase.
    ■ d. demand for vitamin A will increase, causing
    equilibrium price to rise and quantity to fall.
    ■ e. supply of vitamin A will increase, causing equilibrium price to rise and quantity to fall.

    Practice Questions and Problems
    1

    b.

    The high bidder at an
    auction gets a valuable painting.

    c.

    The mayor of a city decides who will be hired.

    d.

    Students at Big Football
    U. can park on campus without charge, but there
    aren’t enough parking spaces for all students.

    2

    List five determinants of demand.

    3

    An increase in income

    (increases,

    decreases) the
    demanded) for haircuts.

    (demand, quantity

    4

    Many Americans have decreased their consumption of
    beef and switched to chicken in the belief that eating
    chicken instead of beef lowers cholesterol. This
    change in tastes has

    An increase in demand
    ■ a. shifts the demand curve to the left.
    ■ b. causes an increase in equilibrium price.
    ■ c. causes a decrease in equilibrium price.
    ■ d. causes a decrease in equilibrium quantity.
    ■ e. does not affect equilibrium quantity.

    decreased) the
    demanded) for beef and
    decreased) the
    quantity demanded) for chicken.
    5

    Which of the following is not a determinant of demand?
    ■ a. income
    ■ b. tastes
    ■ c. prices of resources
    ■ d. prices of complements
    ■ e. consumers’ expectations

    Write the type of allocation method each example
    represents. Choose from the following: random allocation; market allocation; first-come, first-served allocation; or government allocation.
    a.
    Winning a lottery

    (increased,
    (demand, quantity
    (increased,
    (demand,

    If a crisis in the Middle East causes people to expect
    the price of gasoline to increase in the future, then
    demand for gasoline today will
    (increase, not change, decrease).

    6

    If the price of Pepsi increases, the demand for Coke
    and other substitutes will

    .

    10 Which of the following is not a determinant of supply?

    ■ a. prices of resources
    ■ b. technology and productivity
    ■ c. prices of complements
    ■ d. producers’ expectations
    ■ e. the number of producers
    Chapter 2 / Markets and the Market Process

    7

    List five determinants of supply.

    49

    8

    Suppose that a crisis in the Middle East cuts off the
    supply of oil from Saudi Arabia. If S1 is the original
    market supply of oil, draw another supply curve, S2,
    on the graph to show the effect of Saudi Arabia’s de-

    to an
    quantity demanded.

    (increase, decrease) in

    14 If design changes in the construction of milk cartons

    cause the cost of production to decrease, we can expect the
    (demand for, supply

    parture from the market. The
    (quantity supplied, supply) has
    (increased, decreased).

    of) cartons to

    (increase, decrease),

    the equilibrium price to

    , and the

    equilibrium quantity to

    S1

    .

    Price

    15 The following graph shows the market for corn. The

    equilibrium price is

    , and the

    equilibrium quantity is
    . If
    the price of corn is $14, the quantity demanded will
    be

    Quantity

    , and the quantity supplied

    will be
    9

    If the price of tomato sauce increases, the

    of

    (supply, quantity supplied)
    of pizza will

    . A(n)
    units will develop, caus-

    ing the price and quantity supplied to

    (increase, decrease).

    and the quantity demanded to
    . If
    the price is $4, the quantity demanded will be

    10 A new process for producing microchips is discovered

    , and the quantity supplied

    that will decrease the cost of production by 10 percent.
    The supply of microchips will
    (increase, decrease, not change), which means the supply curve will
    right, shift to the left, not change).

    will be

    . A(n)

    of

    units will develop, caus-

    (shift to the
    ing the price and quantity supplied to
    and the quantity demanded to

    11 A paper manufacturer can produce notebook paper

    or wedding invitations. If the price of wedding invitations skyrockets, we can expect the supply of

    .

    20

    S

    18

    (notebook paper, wedding
    invitations) to
    crease).

    ,

    16

    (increase, de-

    14

    12 Shortages lead to an

    (increase, decrease) in price and quantity supplied and
    to an
    quantity demanded.

    (increase, decrease) in

    Price

    12
    10
    8
    6
    4
    2

    13 Surpluses lead to an

    (increase, decrease) in price and quantity supplied and

    50

    D
    0

    2

    4

    6

    8

    10

    12

    14

    16

    18

    20

    22

    24

    26

    28

    30

    Quantity

    Part One / The Price System

    sources, changes in technology or productivity, producers’ expectations, number of producers, and prices
    of related goods or services (goods that are substitutes
    or complements in production).
    a. There is a change in tastes toward batteryoperated dancing gorillas.
    b. The price of plastic falls.
    c. A technological breakthrough makes it cheaper to
    produce plastic flowers.
    d. Consumers’ incomes rise.
    e. The price of battery-operated dancing gorillas
    rises.
    f. The price of plastic for making flowers skyrockets.
    g. A fire destroys a major production facility for
    dancing flowers.
    h. Consumers expect lower prices for dancing flowers in the future.

    Use the following table to answer questions 16
    through 19.
    Price

    Quantity Demanded

    Quantity Supplied

    24
    20
    16
    12
    8
    4
    0

    0
    2
    4
    6
    8
    10
    12

    $0
    1
    2
    3
    4
    5
    6

    16 The equilibrium price is

    .

    17 The equilibrium quantity is

    .

    18 If the price is $2, a

    of
    units will develop, causing

    the price to

    .

    Supply

    Price

    Quantity

    a.
    of

    b.

    units will develop, causing

    c.

    19 If the price is $5, a

    the price to

    Demand

    .

    d.
    e.

    I

    The Market for Battery-Operated Dancing Flowers

    For each event listed below, indicate whether it affects
    the demand or supply of battery-operated dancing
    flowers and the direction (increase or decrease) of the
    change. Also indicate what will happen to equilibrium
    price and quantity. Remember, the determinants of demand are income, tastes, prices of related goods or
    services, consumers’ expectations, and the number of
    buyers. The determinants of supply are prices of re-

    Chapter 2 / Markets and the Market Process

    f.
    g.
    h.

    ✸✔

    ACE s

    Exercises and Applications

    -test
    elf

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    51

    Chapter 3

    ?

    Fundamental
    Questions

    1. In a market system,
    who determines what
    is produced?
    2. Why do different
    people earn different
    incomes, and why do
    different jobs pay
    different wages?
    3. Why is illegal
    immigration an
    issue?
    4. When the government intervenes in
    the market by setting
    a price floor or price
    ceiling, what is the
    result?
    5. When the government intervenes in
    the market with a
    tariff, what is the
    result?
    6. When the
    government restricts
    the quantity that can
    be sold, what occurs?
    7. What is the effect of
    a ban on a good,
    service, or resource?

    52

    Applications of Demand
    and Supply

    A

    recent newspaper article noted that the city
    commission that oversees the rents at
    mobile home parks approved a 4 percent
    rent increase at the Soledad Trailer Lodge rather than the 13.7 percent hike the
    manager proposed. The higher increase was rejected because management had
    failed to take good care of the park, panel member Leslee Bowman said. “It’s a
    slum,” she said. “The roads are cracking, the septic tanks are leaking. The wiring
    appears to be inadequate.” The landlord claims that he is losing money and yet continues to maintain facilities as much as he can.
    What is the reason the landlord and tenants are fighting? What are their incentives? What do they want? The landlord wants to make money—as much as possible. The renters want quality housing that is cheap—the cheapest possible. It seems
    there is a conflict. But such conflicts occur all the time in a market system. Customers want quality products at low prices, and suppliers want to make huge profits. When you purchase a book, you want a quality book at a low price. When the
    book publishers offer their books for sale, they want to get a very high price for the
    books. You pay what you have to pay to get the book, and the publishers sell for
    the prices that the books will sell at. Buyers and sellers want different things, but
    the result of their conflicts is a price at which the product sells.
    In a market system, the interaction of buyers and sellers determines the price of
    products being traded. As we noted in the previous chapter, sometimes people
    don’t like the market outcome and seek another way to allocate the same resources.
    In the landlord–tenant case, the market is not allowed to work to find equilibrium
    price and quantity. The government controls rents. Why? Because some people did
    not like the market outcome. What’s the result of interfering with the market, that
    is, switching to the government as the allocator? We’ll return to this question later
    in the chapter. Before we do that, we have to understand how markets work. This
    means examining demand and supply.
    In the previous chapter we examined a hypothetical market for DVD rentals in
    order to represent what goes on in real markets. We established that the rental price
    of the DVD is defined by equilibrium between demand and supply. We found that
    an equilibrium could be disturbed by a change in demand or a change in supply. Let’s
    now look to some real markets and examine how they function. ■

    Preview

    Part One / The Price System

    ?
    1. In a market system,
    who determines what is
    produced?

    1. THE MARKET FOR LOW-CARB FOODS
    In the 1980s, Americans learned the terms low-fat, nonfat, and fat-free. Food companies scrambled to create low-fat alternatives to everything from hamburgers to
    ice cream. In 2004, a new term appeared: low-carb. The Atkins diet reinforced
    what many nutritionists were proclaiming about the health benefits of reducing
    carbohydrates and increasing protein. From TV beer commercials to the ice cream
    freezer of the local grocer, everything seemed to be presented as a low-carb food.
    Sales of white rice, pasta, breads, and other carbohydrate foods dropped significantly, and manufacturers switched what they were producing. Stouffer’s, Sara Lee,
    Coors, and Hershey’s came up with low-carb products. Even Nabisco SnackWells,
    once marketed as fat-free, were sold as a low-carb product. Burger King, Subway,
    Baja Fresh, Hardee’s, Blimpie’s, TGIF, Ruby Tuesday’s, and Applebee’s presented
    low-carb options. The supermarket filled up with new low-carb products as well. A
    low-carb Sara Lee white bread might be teamed with Skippy “Carb Options” peanut
    butter, or a burger with Heinz’s One-Carb Ketchup might be served with a low-carb
    Michelob Ultra and low-carb Tostitos. Businesses responded to what consumers were
    willing and able to buy. And when some 30 million or more consumers wanted lowcarb options, these options were provided. Resources were reallocated from high-fat
    foodstuffs to low-carb foodstuffs. In 2006 and 2007, many people returned to carbohydrates and switched back from the low-carb products. However, they also switched
    away from foods that contained trans fats. People learned that trans fats could be
    unhealthy and started looking for foods that did not have trans fat as an ingredient.
    A change in consumer tastes is typically followed by a change in the willingness
    of consumers to buy a good or service. This alters demand since demand is defined
    to be the willingness and ability of people to purchase a good or service. In the case
    of low-carb foods, the demand increased.
    To illustrate how resources get allocated in the market system, let’s look at the
    market for low-fat and low-carb foods. Figure 1 shows the market for low-fat
    meals. The demand curve, D1, shows that as the price of a low-fat meal declines,
    the quantity of low-fat meals demanded rises. The supply curve, S, shows that
    restaurants and supermarkets are willing to offer more low-fat meals as the price

    Chapter 3 / Applications of Demand and Supply

    53

    Figure 1
    A Demand Change in the Market for Low-Fat Food
    In Figure 1(a), the initial market-clearing price (P1) and
    market-clearing quantity (Q1) are shown. In Figure
    1(b), the market-clearing price and quantity change

    from P1 and Q1 to P2 and Q2 as the demand curve shifts
    to the left because of a change in tastes. The result of decreased demand is a lower price and a lower quantity
    produced.

    (b) The Effect of a Change in Tastes

    (a) Low-Fat Food Market

    9

    8

    S

    7
    6
    5

    e1

    4

    P1 = 4
    Q1 = 100

    3

    8

    S

    7
    6
    5

    P1 = 4
    Q1 = 100

    e1

    4

    e2

    3

    P2 = 3
    Q2 = 80

    2

    2
    1
    0

    Price per Meal (dollars)

    Price per Meal (dollars)

    9

    D1
    25

    50

    75

    100

    125

    150

    Quantity (number of meals/hour)

    1
    0

    D2
    25

    50

    75

    80

    100

    125

    D1
    150

    Quantity (number of meals/hour)

    of a low-fat meal rises. The demanders are the consumers, the people who want
    low-fat food. The suppliers are the firms—Taco Bell, McDonald’s, Burger King,
    and so on. With these demand and supply curves, the equilibrium price (P1) is $4,
    and the equilibrium quantity (Q1) is 100 units (low-fat meals) per hour. At this
    price–quantity combination, the number of low-fat meals demanded equals the
    number of low-fat meals sold; equilibrium is reached.
    The second part of the figure shows what happens when consumer tastes change;
    people preferred to have low-carb food rather than low-fat food. This change in tastes
    caused the demand for low-fat meals to decline and is represented by a leftward shift
    of the demand curve, from D1 to D2, in Figure 1(b). The demand curve shifted to the
    left because fewer low-fat meals were demanded at each price. Consumer tastes, not
    the price of low-fat meals, changed first. (Remember: A price change would have led
    to a change in the quantity demanded and would be represented by a move along demand curve D1, not a shift of the demand curve.) The shift from D1 to D2 created a
    new equilibrium point. The equilibrium price (P2) decreased to $3, and the equilibrium quantity (Q2) decreased to 80 units (low-fat meals) per hour.
    While the market for low-fat meals was changing, so was the market for low-carb
    food. People substituted low-carb meals for low-fat meals. Figure 2(a) shows the
    original demand for low-carb food. Figure 2(b) shows a rightward shift of the demand curve, from D1 to D2, representing increased demand for low-carb meals. This
    demand change resulted in a higher market-clearing price for low-carb meals, from
    $5 to $6.
    As the market-clearing price of low-fat food fell (from $6 to $5 in Figure 1[b]),
    the quantity of low-fat meals sold also declined (from 100 to 80) because
    the decreased demand, lower price, and resulting lower profit induced some firms
    to decrease production. In the low-carb business, the opposite occurred. As the

    54

    Part One / The Price System

    Figure 2
    A Demand Change in the Market for Low-Carb Food
    In Figure 2(a), the initial market-clearing price (P1) and
    quantity (Q1) are shown. In Figure 2(b), the demand
    for low-carb food increases, thus driving up the
    (a) Delivery Market

    (b) The Effect of a Change in Tastes

    S

    8
    7
    6

    e1

    5
    4

    S

    9

    Price per Meal (dollars)

    Price per Meal (dollars)

    9

    P1 = 5
    Q1 = 50

    3
    2

    8
    7

    e2

    6

    e1

    5
    4

    P2 = 6
    Q2 = 60
    P1 = 5
    Q1 = 50

    3
    2

    1
    0

    market-clearing price (P2) and quantity (Q2), as the demand curve shifts to the right, from D1 to D2.

    1

    D1
    25

    50

    75

    100

    125

    150

    Quantity (number of meals/hour)

    0

    D1
    25

    50 60 75

    100

    D2
    125

    150

    Quantity (number of meals/hour)

    market-clearing price rose (from $5 to $6 in Figure 2[b]), the number of low-carb
    meals also rose (from 50 to 60). The increased demand, higher price, and resulting
    higher profit induced firms to increase production.
    Why did the production of low-carb foods increase while the production of low-fat
    foods decreased? Not because of government decree. Not because of the desires of
    the business sector. The consumer made all this happen. Businesses that failed to respond to consumer desires and provide the desired good at the lowest price failed to
    survive. Why does the consumer wield such power? The name of the game for business is profit, and the only way business can make a profit is by satisfying consumer
    wants. In the market system, the consumer, not the politician or the business firm, ultimately determines what is to be produced. A firm that produces something that no
    consumers want will not remain in business very long. Consumer sovereignty—the
    authority of consumers to determine what is produced through their purchases of
    goods and services—dictates what goods and services will be produced.
    After demand shifted to low-carb food, the resources that had been used in the
    low-fat food preparation and sale were available for use elsewhere. Some of the
    equipment used for preparing low-fat foods—ovens, pots, and pans—was purchased by the low-carb firms, and some was sold as scrap or to restaurants. Even
    ingredients that previously would have gone to the low-fat foods were bought by
    the firms producing low-carb foods. In other words, the resources moved from an
    activity in which their value was relatively low to an activity in which they were
    more highly valued. No one commanded the resources to move. They moved because they could earn more in some other activity.
    Markets allocate scarce goods and resources to the place where they have the
    highest value. Markets exist not only for products but also for resources—land,
    labor, and capital. Let’s discuss a few examples of this allocation process. Let’s
    turn now to the market for labor.
    Chapter 3 / Applications of Demand and Supply

    55

    1. The market price is the equilibrium price, established where demand and
    supply are equal.
    2. If demand or supply changes, then the equilibrium price and the quantity purchased will change.
    3. When demand changes, the price changes, and the quantity produced and
    purchased changes, and thus the resources that are used to produce and sell
    the product change.

    R E C A P

    ?

    2. THE LABOR MARKET

    2. Why do different people
    earn different incomes,
    and why do different
    jobs pay different
    wages?

    Older workers tend to earn higher wages than younger workers, males earn more
    than females, whites earn more than African Americans and Latinos, and unionized
    workers earn more than nonunionized workers. Why? The answer is given in the labor market. The labor market consists of the demand for and the supply of labor.
    Labor demand depends on the value of workers to the firm. How many workers
    does a firm hire? Those that bring in at least as much revenue for the firm as they cost
    the firm in wages and salaries would be valuable to the firm; they would be hired.
    The higher the price of labor (the more it costs the firm), the less labor that the firm
    will demand. Thus, the labor demand curve slopes down.
    The labor supply comes from households. People decide whether to work and
    how many hours to work at each possible wage. The higher the hourly wage, the
    more hours that people are willing and able to work, at least up to a point. In

    Global Economic Insight

    Jobs Moving Offshore

    Type

    2005

    2015

    Business

    61,252

    Computer

    108,991

    472,632

    37,477

    288,281

    32,202

    184,347

    Management
    Architecture
    Office
    All Other
    Total

    348,028

    295,034 1,659,310
    52,636

    367,615

    587,592 3,320,213

    Resources flow to where they have
    the highest value. If the resources
    cannot flow—for example, if workers

    56

    in China or India can90
    not move to the
    80
    United States—then
    the uses of the re70
    sources will go to
    60
    where the costs are
    Manufacturing
    50
    lowest; in other
    Services
    40
    words, the jobs flow
    to the workers. The
    30
    movement of re20
    sources occurs within
    10
    a country just as it
    does among coun0
    1950
    2002
    tries. The graph above
    shows how the U.S.
    disappeared as the auto appeared;
    economy has shifted from manufacthe slide rule manufacturers
    turing to services over the past
    disappeared as the calculator and
    several decades. An economy in
    then the PC appeared. In each case,
    which voluntary trade occurs will see
    workers displaced by the changes
    a constant shift of uses of resources.
    were hurt; the new jobs created
    As it does, jobs will disappear in
    benefited those who had acquired
    some uses and increase in others.
    the skills necessary to get one of the
    The buggy whip manufacturers
    newly created jobs.
    % of Non-farm Workers Employed

    T

    he U.S. Department of Labor estimates, based on trends noted
    in 2003 and 2004, that 3.3 million jobs currently in the United
    States will be moved out of the
    United States by 2015.

    Part One / The Price System

    Figure 3

    S

    Labor Market Equilibrium
    Wage Rate per Hour (dollars)

    If all workers are identical to
    firms—that is, if a firm doesn’t
    care whether it hires Bob, Raj,
    Keiko, or Allie—and if all firms
    and jobs are the same to
    workers—that is, if a worker
    doesn’t care whether a job is
    with IBM or Ted’s Hot Dog
    Stand—then one demand
    curve and one supply curve
    define the labor market. The
    intersection of the two curves
    is the labor market equilibrium at which the wage rate
    is determined.

    We

    D

    Qe
    Quantity (number of hours/year)

    addition, some people who would not be willing to work at a low wage may decide
    to enter the labor force if the wage gets high enough. This means that the labor
    supply curve slopes up.
    The labor demand and labor supply curves are shown in Figure 3. The intersection
    of the labor demand and labor supply curves determines the equilibrium wage (We )
    and the quantity of hours people work at this equilibrium wage (Qe ).
    The labor market pictured in Figure 3 suggests that as long as workers are the
    same and jobs are the same, there will be one equilibrium wage. In fact, workers
    are not the same, jobs are not the same, and wages are definitely not the same.
    College-educated people earn more than people with only a high school education,
    and people with a high school education earn more than those with only a grammar
    school education. Riskier jobs pay more than less risky jobs. There is, in reality, a
    labor market for each type of worker and each type of job.
    Some jobs are quite unpleasant because they are located in undesirable locations
    or are dangerous or unhealthy. How does a firm get someone to take a dangerous or
    unhealthy job? People choose to work in unpleasant occupations because they earn
    more money. Workers mine coal, clean sewers, and weld steel beams fifty stories
    off the ground because, compared to alternative jobs for which they could qualify,
    these jobs pay well.
    In Figure 4, two labor markets are represented: one for a risky occupation and one
    for a less risky occupation. At each wage rate, fewer people are willing and able to
    work in the risky occupation than in the less risky occupation. Thus, if the demand
    curves were identical, the supply curve of the risky occupation would be above (to the
    left of) the supply curve of the less risky occupation. Fewer people are willing to take
    the riskier job than the less risky job if the riskier job pays the same as the less risky
    job. As a result, the equilibrium wage rate in the risky occupation, $60 per hour, is
    higher than the equilibrium wage rate in the less risky occupation, $35 per hour. The
    difference between the wage in the risky occupation and the wage in the less risky is
    an equilibrium differential—the compensation a worker receives for undertaking the
    greater risk. Unlike the low-carb versus low-fat foods where a differential profit
    shifted resources from one to the other, this price differential will not attract more
    workers from the less risky occupation to the risky one. This wage difference is an
    equilibrium differential—the amount needed to offset the additional risk.

    Chapter 3 / Applications of Demand and Supply

    57

    Figure 4
    Compensating Wage Differential
    Figure 4(a) shows the market for a risky occupation.
    Figure 4(b) shows the market for a less risky occupation.
    At each wage rate, fewer people are willing and able to
    work in the risky occupation than in the less risky occupation. Thus, the supply curve of the risky occupation is
    higher (supply is less) than the supply curve of the less
    risky occupation. As a result, the wage ($60 per hour) in
    the risky occupation is higher than the wage ($35 per
    (a) Risky Occupation

    hour) in the less risky occupation. The differential ($60 –
    $35 = $25) is an equilibrium differential—the amount necessary to induce enough people to fill the jobs. If the differential were any higher, more people would flow to the
    risky occupation, driving wages there down and wages in
    the less risky occupation up. If the differential were any
    lower, shortages would prevail in the risky occupation,
    driving wages there up.
    (b) Less Risky Occupation

    S
    Wage Rate per Hour (dollars)

    Wage Rate per Hour (dollars)

    S

    Differential = $25
    60

    35

    D

    Quantity (number of hours/year)

    35

    D

    Quantity (number of hours/year)

    Some jobs are more dangerous
    than others. Since fewer people
    are willing to work in dangerous
    jobs if they pay the same as less
    dangerous jobs, it is necessary for
    employers to pay more for dangerous jobs. To induce people to
    climb tall buildings to wash windows, to construct skyscrapers, or
    to paint the Golden Gate Bridge,
    the pay must be increased. Some
    employees undertaking risky jobs
    earn more in two months than
    they could in a year undertaking
    a less risky job.

    58

    Part One / The Price System

    Figure 5
    Skilled and Unskilled Labor
    Two labor markets are pictured. Figure 5(a) shows the
    market for skilled labor. Figure 5(b) shows the market for

    unskilled labor. The smaller supply in the skilled-labor
    market results in a higher wage there.
    (b) Unskilled-Labor Market

    (a) Skilled-Labor Market

    S
    Wage Rate per Hour (dollars)

    Wage Rate per Hour (dollars)

    S

    Differential = $27
    35

    8

    D

    Quantity (number of hours/year)

    Now You Try It
    A PA (physician’s assistant)
    earns about $65,000 per year
    while a physician earns
    $200,000 per year. Explain the
    difference in salaries.

    compensating wage
    differential: wage differences
    due to different risks or job
    characteristics

    8

    D

    Quantity (number of hours/year)

    Commercial deep-sea divers are exposed to the dangers of drowning and several
    physiological disorders as a result of compression and decompression. They
    choose this job because they earn about 90 percent more than the average
    high school graduate. Coal miners in West Virginia and in Wales in the United
    Kingdom are exposed to coal dust, black lung disease, and cave-ins. They choose
    to work in the mines because the pay is twice what they could earn elsewhere.
    Wage differentials ensure that deep-sea diving jobs, coal-mining jobs, and other
    risky occupations are filled.
    Any characteristic that distinguishes one job from another may result in a
    compensating wage differential. A job that requires a great deal of travel and
    time away from home usually pays more than a comparable job without the travel
    requirements because most people find extensive travel and time away from
    home to be costly. If people were indifferent to travel, there would be no wage
    differential.
    People differ with respect to their tastes for risky jobs, but they also differ with
    respect to their training and abilities. These differences influence the level of
    wages for two reasons: (1) skilled workers are more valuable to most firms than
    unskilled workers, and (2) the supply of skilled workers is smaller than the supply
    of unskilled workers because it takes time and money to acquire training and education. These things mean that skilled labor will earn higher wages than less
    skilled labor. For instance, in Figure 5, the skilled-labor market results in a wage
    of $35 per hour whereas the unskilled-labor market results in a wage of $8 per
    hour. The difference exists because the demand for skilled labor relative to the
    supply of skilled labor is greater than the demand for unskilled labor relative to
    the supply of unskilled labor.

    Chapter 3 / Applications of Demand and Supply

    59

    35

    Foreign-Born Population of
    the United States

    30

    30

    25

    25

    Source: “Foreign-Born Population
    of the United States,” Current
    Population Survey, March 2004
    and previous years; http://
    www.census.gov/population
    /www/socdemo/foreign
    /ppl-176.html.

    33 million
    (2003)

    35

    20

    20

    14.8%
    15

    15

    11%

    Percent

    10

    Percent of Total

    The foreign-born population of
    the United States in numbers
    and percentages is shown for
    the period from 1860 to 2000.
    The amounts (total numbers
    and percentages) rose until
    the early 1900s, then declined
    until the late 1960s and have
    risen since.

    Population (millions)

    Figure 6

    10

    5

    5

    Population
    1840

    1860

    1880

    1900

    1920

    1940

    1960

    1980

    2000

    Year

    2.a. Illegal Immigration

    ?
    3. Why is illegal
    immigration an issue?

    60

    Approximately 700,000 people cross legally into the United States from Mexico
    every day to shop and work, returning afterwards to their homes in Mexico. About
    3,500 people cross the border illegally every day, and many of them don’t return to
    Mexico. In the United States, the illegal population from Mexico is estimated to be
    between 6 and 7 million. Another 3 to 4 million undocumented aliens living in the
    United States are from other Latin American countries and Asia.
    Why do so many people leave their home countries and migrate to the United
    States? What societal effects do immigrants, and especially illegal immigrants,
    have? Answers to these questions are varying and controversial. But since the
    effect of immigration on labor markets depends on the demand for and supply of
    labor, it is not so controversial.
    In Figure 6 you can see the pattern of legal immigration to the United States
    from about 1850. It has not happened at a steady pace, but instead has been cyclical, with a peak in the number of people coming to the United States from other
    countries occurring in the 1920s and currently.
    The amount of immigration relative to the existing population is also shown in
    Figure 6. The total foreign-born population as a percentage of the total U.S. population declined from a peak in 1880 and 1910 of about 15 percent to a low of
    5 percent around 1970 and has risen since.
    People leave their home country and go to another country to live primarily
    because they seek a higher quality of life. Their own country may be politically
    repressive or economically stagnant, or there may be no upward mobility among
    income classes in their home country. For instance, most immigrants to the United
    States in the 1800s and 1900s were from northern and western Europe. Economic
    events like the potato famine in Ireland, recessions in the United Kingdom and
    western Europe, and religious persecution led to migrant flows to the United
    States. Beginning about 1950, immigration to the United States switched from
    being primarily from Europe to being mostly from Latin America and Asia.
    The change was caused by changes in U.S. immigration policy and the relatively
    more severe political and economic problems in the Asian and Latin American
    countries.

    Part One / The Price System

    90

    Illegal Immigration in the
    United States as a Percentage
    of Total Immigration
    The number of illegal
    immigrants as a percentage of
    total immigrants is shown for
    the period 1965–2004. The
    percentage rose until the early
    1980s, then declined until the
    mid-1990s and rose until the
    current period.
    Source: Jeffrey S. Passel and
    Roberto Suro, Pew Hispanic Center,
    Rise, Peak and Decline: Trends in
    U.S. Immigration 1992–2004.

    Illegal as Percentage of Total Immigration

    Figure 7

    80
    70
    60
    50
    40
    30
    20
    10
    1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005

    Year

    For example, the greatest number of recent immigrants to the United States
    comes from Mexico. Compare income—the per capita income in the United States
    is $42,000, and in Mexico it is $9,000. These are average figures, but just for perspective, a single person in the United States earning $9,000 would be legally considered to be in poverty.
    2.a.1. Why Immigrate Illegally? As Figure 7 shows, illegal immigration is a
    significant percentage of immigration and has been growing rapidly in the past few
    years. However, fewer than half of illegal immigrants cross the nation’s borders
    clandestinely; most illegal immigrants enter legally and overstay their visas.
    For much of U.S. history, there were few restrictions on immigration, so illegal
    immigration was not an issue. The first restriction was the Chinese Exclusion Act
    of 1882. Chinese immigrants had been brought in to work during the labor shortages of the 1840s, but they became increasingly disliked by the native unskilled laborers. The Chinese Exclusion Act suspended immigration of Chinese laborers for
    ten years, removed the right of Chinese entrants to be naturalized, and provided for
    the deportation of Chinese who were in the United States illegally. It was not until
    1943 that the Chinese exclusion laws were repealed. In 1924, the United States established a quota system specifying how many people from each country could immigrate to the United States each year. The law placed a ceiling of 150,000 per year
    on immigrants from Europe, completely barred immigrants from Japan, and based
    the admission of immigrants from other countries on the proportion of people of
    that national origin that were present in the United States as measured by the 1890
    census. In 1965, the national origins quota system was replaced with a uniform
    limit of 20,000 immigrants per country for all countries outside the Western
    Hemisphere and a limit on immigration from the Western Hemisphere (most
    notably from Mexico). The Immigration Reform and Control Act of 1986 (IRCA)
    was the first to address the issue of illegal imigration. It introduced penalties for
    employers who knowingly hire illegal immigrants.
    The United States currently admits about 700,000 immigrants annually as legal
    (“green card”) residents who will be eligible to apply for citizenship after living in
    the United States for five years. Only about 110,000 of those receiving green cards
    do not have family members who are U.S. citizens. Of these, about 65,000 are
    highly skilled workers on H1-B visas, and about 44,000 are low-skilled workers.

    Chapter 3 / Applications of Demand and Supply

    61

    Figure 8

    Supply without
    Illegal Immigrants

    Without illegal immigrants, the
    equilibrium wage is $15, and
    the equilibrium quantity is
    quantity 0–Q1. With illegal immigration, the supply increases
    and the wage rate declines to
    $9. At $9, there would be a
    shortage of B–C if no illegal immigrants supplied labor.

    Wage for Unskilled Labor

    Unskilled Labor Market and
    Illegal Immigration

    $9

    Supply with
    Illegal
    Immigrants

    A

    $15

    B

    C
    Demand

    Q1

    Q2

    Quantity of Unskilled Labor

    To understand what these developments mean, we need to look at the unskilled
    labor market as depicted in Figure 8. The equilibrium wage is $15 per hour if only
    legal immigrants and natives are considered. Now, what happens when illegal
    immigration takes place? The supply of low-skilled labor rises—the supply curve
    shifts out—and the equilibrium wage drops to $9 per hour. At $9, fewer natives
    choose to work—the quantity supplied of native workers declines from A to B. The
    shortage of native workers, B to C, is made up by illegal immigrants.
    Have you heard the claim that illegal immigrants take jobs that Americans won’t
    take? Those making this claim are focusing on the distance from B to C in Figure 8.
    What they are not including in their discussion is the distance from A to B caused
    by the lower wage. What the claim actually should say is that illegal immigrants
    take jobs that Americans won’t take at the wage rate for these jobs. If the wage rate
    was $15, then enough native workers would be willing to work to match the quantity demanded.
    Labor is a resource—it is used to produce goods and services, and the wages and
    salaries provided to workers are part of the costs of doing business. So, when the
    cost of labor declines, the costs of doing business also decline. A typical firm will
    produce more and earn greater profits when its costs decline. As firms increase
    their output and new firms enter the business, the market supply of the products being produced by the unskilled labor will rise, and the market price of the good or
    service will decline. This is what happens with illegal immigration. Illegal immigration has reduced costs in certain businesses— construction, restaurants, agriculture, meatpacking, textiles, and poultry production in particular. The lower costs
    lead to lower prices for houses and buildings, child care, housekeeping, gardening,
    produce, poultry, meats, and restaurants.

    2.b. Immigration Policy
    Illegal immigration in the United States is one of the topics of greatest concern to
    the American public. The costs and benefits of illegal immigration have been examined in a number of studies. The costs include the effects of illegal immigration
    on unskilled workers, and the benefits include the lower prices for some goods and
    services. Other costs are the property damage caused by immigrants sneaking into
    the United States and the expenditures on health care for immigrants at emergency
    clinics and hospitals, which are legally unable to deny care to anyone or to inquire
    whether someone is a legal resident. Another cost is the expenditures on public

    62

    Part One / The Price System

    education for the children of immigrants who attend public schools. Still another
    cost involves burglaries and other crimes committed by illegal immigrants.
    Benefits created by the illegal immigrants include the taxes they pay. It is
    estimated that about three-fourths of illegal immigrants pay social security and
    other withholding taxes, but since an illegal immigrant must have fake identification
    and social security numbers, any payments made to social security will not be
    assigned to a potential recipient. Instead, when the social security number does not
    match the SSA’s records, the payments go into a slush fund called the “suspense file.”
    Since 2002, the suspense file has been growing by more than $60 billion a year. The
    net effect of these costs and benefits varies according to the study, but most studies
    conclude that the first generation of illegal immigrants imposes costs that exceed the
    benefits they create, but every generation thereafter creates more benefits than
    it costs.
    Those most affected by the benefits want immigrants to have a way to take a job,
    while those most affected by the costs want immigrants kept out of the country.
    Views on illegal immigration range from using the military to guard the borders to
    support for some form of amnesty for illegal aliens already in the United States and
    set up a guest worker program.
    As illegal immigration has increased, so have government expenditures on border enforcement. Between 1986 and 2005, the U.S. Border Patrol more than tripled
    in size, and the hours spent patrolling increased more than eight times. In addition
    to the Border Patrol, the U.S. Customs Service and the Immigration and Naturalization Service have intensified their inspections, and the Drug Enforcement
    Agency (DEA) and the Bureau of Alcohol, Tobacco, and Firearms (BATF) have increased their presence. Border apprehensions increased from 200,000 in 1970 to
    more than 2 million in 2004, and yet the apprehension rate—apprehensions per total illegal crossings—declined because the number of crossings had increased more
    quickly.
    What would be the effects of more intense border enforcement? In Figure 8, the
    supply curve would shift in to the “Supply Without Illegal Immigrants” curve as a
    result of the border enforcement. With fewer illegal immigrants, in order to hire
    people to work in restaurants and agricultural fields and other unskilled areas, firms
    would have to pay more. Suppose the wage is driven up to $15. The firms that
    before the increased enforcement had employed the illegal unskilled workers
    would now have to pay more; their costs of doing business would rise. Profits
    would decline, with the result that those that remained in business would not
    produce as much, and fewer firms would be in business. The quantities of the products created by unskilled labor would decline, and the prices of these products
    would rise.

    R E C A P

    1. The labor market consists of the demand for and supply of labor.
    2. The labor supply curve tends to slope up, indicating that the number of hours
    people are willing to work rises as the wage rate rises.
    3. The labor demand curve tends to slope down, indicating that firms will
    employ more people or hire people to work more hours as the wage rate
    declines.
    4. The wage rate and the quantities of workers employed are determined by the
    equilibrium between labor demand and labor supply.
    5. In reality, there are many different labor markets—markets for skilled versus
    unskilled labor, markets for dangerous versus non-dangerous jobs, and so on.
    6. An equilibrium wage differential or compensating wage differential exists
    when the equilibrium wage in two different labor markets is different.

    Chapter 3 / Applications of Demand and Supply

    63

    7. The impact of illegal immigrants on the labor market is to increase the supply
    of unskilled workers, which reduces the wage rate. The lower wage induces
    many native workers to leave the market—to refuse to work at the low wage.
    The lower wage is also a reduced cost for businesses employing illegal immigrants, and the lower cost means lower prices for the goods and services produced by the illegals.
    8. Border enforcement, if effective, would reduce the number of unskilled workers and thereby drive up wages and the cost of business for firms that had been
    employing illegal immigrants. Consumers would be paying higher prices for
    the goods and services produced by the illegals.

    3. EXAMPLES OF MARKET RESTRICTIONS
    You now have an idea of how markets work to allocate scarce goods and resources.
    You also have a brief exposure, via the discussion of immigration, to the fact that
    markets are often not allowed to work. For various reasons, nations do not allow free
    migration from other nations or to other nations. But labor markets are far from the
    only markets where government rules, regulations, and laws restrict the market
    process. In this section we discuss a few types of restrictions.

    3.a. The Market for Medical Care
    One of the issues of greatest concern to people in the last decade or so has been the
    cost of medical care. Since 1990, medical care costs have risen more than 15 percent per year. Let’s look at the market for medical care to see if we can understand
    why the costs have risen so dramatically.
    Equilibrium in a market determines the price (P) and the quantity (Q) purchased/
    sold. Thus, equilibrium also determines total expenditures (price times quantity
    [P  Q]). Total expenditures on health care have risen tremendously during the
    past three decades. In the health care market, rising costs or expenditures mean
    that the demand for medical care has risen relative to supply. This means either that
    demand has increased more than supply or that supply has decreased more than
    demand.
    Suppose the initial demand for medical care is D1 and the supply of medical care
    is S1 in Figure 9. The intersection between demand and supply determines the price
    of medical care, P1. Total expenditures are just P1 times Q1.
    An increase in demand is shown as the outward shift of the demand curve,
    from D1 to D2. This demand increase results in the price of medical care’s rising
    from P1 to P2. The quantity of medical care purchased and sold also rises, from
    Q1 to Q2. Total expenditures on medical care therefore rise from P1 times Q1 to P2
    times Q2.
    Even if the demand curve for medical care were not shifting outward rapidly, the
    cost of medical care could be forced up by an upward shift of the supply curve, as
    shown in Figure 10. The supply curve shifts in from S1 to S2, resulting in an increase in the equilibrium price to P2. Notice, however, that the smaller supply need
    not mean higher total expenditures on medical care because P1  Q1 may be larger
    than P2  Q2. Since it is rising total expenditures we are trying to understand, we
    should look to an increase in demand rather than a decrease in supply.
    What accounts for the rising demand? The aging of the population stimulates the
    demand for health care. The elderly consume four times as much health care per
    capita as the rest of the population. About 90 percent of the expenditures for nursing
    home care are for persons 65 or over, a group that constitutes only 12 percent of the
    population. The elderly (65 or older) currently account for 35 percent of hospital

    64

    Part One / The Price System

    Figure 9
    The Market for Medical
    Care: A Demand Shift

    S1
    Price of Medical Care (dollars)

    The demand for and supply
    of health care determine the
    price of medical care, P1, and
    the total expenditures, P1
    times Q1. Rising health care
    expenditures may be due to
    increased demand. A larger
    demand, D2, means a higher
    price and a greater total
    quantity of expenditures, P2
    times Q2.

    P2
    P1
    D2
    D1
    Q1

    Q2

    Quantity of Medical Care/year

    Now You Try It
    In 2003, Congress passed a law
    that has Medicare provide
    funding with which seniors can
    purchase prescription drugs.
    Using the demand for and supply of prescription drugs, explain what effect the law will
    have.

    expenditures. In contrast, the young, although they constitute 29 percent of the population, consume only 11 percent of hospital care. Per capita spending on personal
    health care for those 85 years of age or over is 2.5 times that for people age 65 to 69
    years. For hospital care, per capita consumption is twice as great for those age 85 or
    over as for those age 65 to 69; for nursing home care, it is 23 times as great.
    For demand to increase, the elderly must be both willing to buy medical care
    and able to pay for it. This is where the government comes in. The general public
    believes that it has a right to decent medical care and voted for those legislators
    who would support this belief. The result was Medicare and Medicaid, government
    programs that purchased medical care for the aged and those unable to afford it.
    These programs provide a subsidy to the aged, enabling them to buy more health
    care than they would buy without the subsidy.

    Figure 10
    The Market for Medical
    Care: A Supply Shift

    S1
    Price of Medical Care (dollars)

    The rising cost of medical
    care may be caused by
    an increase in the costs of
    supplying medical care. The
    supply curve shifts up, from
    S1 to S2, and the price of
    medical care rises, from P1 to
    P2.

    S2

    P2
    P1
    D1
    Q2

    Q1

    Quantity of Medical Care/year

    Chapter 3 / Applications of Demand and Supply

    65

    Subdidy: Payment by government to encourage production
    or purchase of a good.

    The emergence of Medicare and Medicaid in 1966 gave many elderly the ability
    to purchase medical care. These government programs pay for medical expenses.
    The government collects the money with which to pay for the programs using general payroll taxes. This means that many people are able to get medical care without having to pay for it. In any market, if the demanders don’t have to pay for the
    goods and services, they will demand a lot more. This is what has happened in the
    market for medical care.
    The effect of the Medicare and Medicaid programs has been to increase the demand for services. Private sources pay for only about 55 percent of personal health
    care for the general population, and Medicare and Medicaid pick up most of the remainder. For the elderly, the private share of spending is only 15 percent for hospital care, 36 percent for physicians’ services, and 58 percent for nursing home care.
    Medicaid and Medicare pay for the rest.

    3.b. The Market for Human Organs
    Many respected doctors, lawyers, economists, and ethicists argue that a legal and
    open market in organs, such as kidneys, hearts, and livers, could help cure the
    chronic organ shortage that is gripping transplant medicine. If the price is right and
    the seller is willing, why should someone not be allowed to sell a kidney? The debate over the issue is intense. Many who are against an open and free market in
    organs argue that it will result in exploitation of the poor. They point to cases in
    which black market activity has occurred, such as in India’s poorest sectors, where,
    for about $1,500, poor Indians have sold a kidney and in just a few years, are back
    in poverty, with huge debts and with one less kidney. But how people choose to
    spend the money gained from selling an organ has nothing to do with the market
    for the organs. People may fritter away money, but that has nothing to do with
    where they earned the money. The debate over the market for organs must focus on
    the supply of organs and the lives saved or lost because of the existence of a market
    in organs or due to the fact that a market is not allowed.
    Supporters of a free and open market argue that it would increase supplies of
    transplant organs and save many lives. In the United States alone, there are 50,000
    people of dialysis waiting for a donor kidney. About 3,000 people die each year
    while waiting on a kidney transplant. Thousand also die while waiting for livers,
    hearts, and other vital organs, and the number of people dying is increasing each
    year.
    How would the legal market work? One part of the market would be the purchase
    of organs from living individuals. A person would offer a kidney or a part of a liver
    (since only pieces of livers, not whole livers, are needed for transplant) for a price.
    The price would be set by demand and supply. A second part of the market would be
    organs harvested from people who die suddenly, such as those killed in accidents.
    These people would have sold their organs, such as lungs, hearts, and kidneys, in
    what can be called a “futures” market. The rights to harvest these organs after death
    could be purchased from donors while they were still living, at prices set by supply
    and demand. Donors would be paid for future rights to their organs. So you could
    sell the rights to your kidneys once you die and receive the payment today.
    What would the outcome of such a market be? Let’s use Figure 11 to illustrate
    the market for organs. The demand for organs would slope down because as the
    price rises, fewer people could afford the organs. The supply of organs would slope
    up, since more organs would be offered for transplant as the price rose. For instance, a 10 percent increase in the price, say from $100,000 to $110,000, would
    induce more people to offer their organs now. And if a futures market developed,
    the supply would be price-elastic, since everyone who now volunteers to donate organs would rise even more, and many others would also do so because they would
    receive some income for almost no cost. The market for human organs would look
    something like Figure 11, where the equilibrium price would be P1 and the equilib66

    Part One / The Price System

    Figure 11
    The Market for Human
    Organs

    S

    Price

    The demand for transplant
    organs and the supply of
    organs offered for transplant
    would determine the
    equilibrium price and
    quantity.

    B

    P

    Shortage

    A

    C
    D
    Q1
    Quantity/Time

    rium quantity Q1. What would the price be? In the United States in 2000, a kidney
    was auctioned on eBay. The government terminated the auction after only a few
    hours, but when it was stopped, the price had reached $5 million. At the other end
    of the price range, the black market (illegal market) price of a kidney in India was
    about three times the average annual income, or $1,500. Some studies predict that
    the supply of organs and the alternatives to organs created by technological
    changes spurred by the profits possible should drive prices to a very low level, perhaps $200, in just a matter of years.1
    A black market arises when an item that some people are willing and able to buy
    and others are willing and able to supply cannot be legally traded. Black markets
    are less efficient or more costly than legal markets simply because traders have to
    be discreet, cannot meet buyers and sellers openly, and have no means to enforce
    agreements. As a result, the number of traders in the market is less than it would be
    in a legal market. Most of the evidence available regarding human organs shows
    that the market would be immensely larger if it were legal than the black market in
    human organs currently is.
    The problem that most people have with the idea of a market in human organs
    is the potential for what they call exploitation. They point out that the organs
    would be going one way—from poor people to rich people, from the Third World
    to the First World or to rich people in the Third World. This is the way markets
    work—from those who are willing and able to sell to those who are willing and
    able to buy. Arguing that this result is bad is a normative argument, not a positive
    one. Similarly, the counterargument that a father who is desperate to provide a plate
    of rice for his starving family should be entitled to sell one of his kidneys on the
    open market is a normative argument. No matter what the normative viewpoints,
    there is a market for human organs; transplant surgery is a business driven by the
    simple market principle of supply and demand. The positive aspect of the issue
    is not who would gain and who would lose in a free, open market, because both

    1

    David L. Kaserman and A. H. Barnett, The U.S. Organ Procurement System: A Prescription for
    Reform (Washington D.C., The AEI Press, 2002.)

    Chapter 3 / Applications of Demand and Supply

    67

    ?

    buyers and sellers gain, but instead, how does the current black market situation
    compare with a free, open, legal market?

    3.c. Price Ceilings: The Market for Rental Housing
    4. When the government
    intervenes in the
    market by providing a
    subsidy, what is the
    result?

    price ceiling: a specific level
    above which price is not
    allowed to rise

    Equilibrium is established by the interaction of buyers and sellers; the market price
    and the quantity produced and sold are defined at the point where the demand and
    supply curves intersect. Looking at last year’s sweaters piled up on the sale racks,
    waiting over an hour for a table at a restaurant, finding that the DVD rental store
    never has a copy of the movie you want to rent in stock, or hearing that 5 or 6 percent of people willing and able to work are unemployed may make you wonder
    whether equilibrium is ever established. In fact, it is not uncommon to observe situations in which quantities demanded and supplied are not equal. But this observation does not cast doubt on the usefulness of the equilibrium concept. Even if all
    markets do not reach equilibrium all the time, we can be reasonably assured that
    market forces are operating so that the market is moving toward an equilibrium.
    The market forces exist even when the price is not allowed to change.
    A price ceiling is the situation in which a price is not allowed to rise to its
    equilibrium level. Los Angeles, San Francisco, and New York are among more
    than 125 U.S. cities that have rent controls. A rent control law places a ceiling on
    the rents that landlords can charge for apartments. Figure 12 is a demand and supply graph representing the market for apartments in New York. The equilibrium
    price is $3,000 a month. The government has set a price of $1,500 a month as the
    maximum that can be charged. The price ceiling is shown by the yellow line. At the
    rent control price of $1,500 per month, 3,000 apartments are available but consumers want 6,000 apartments. There is a shortage of 3,000 apartments.
    The shortage means that not everyone willing and able to rent the apartments
    will be allowed to. Since the price is not allowed to ration the apartments, something else will have to. It may be that those willing and able to stand in line the
    longest will get the apartments. Perhaps bribing an important official might be the
    way to get an apartment. Perhaps relatives of officials or important citizens will get
    the apartments. Whenever a price ceiling exists, a shortage results, and some rationing device other than price will arise.

    Figure 12

    S

    A demand and supply graph
    representing the market for
    apartments in New York City
    is shown. The equilibrium
    price is $3,000 a month. The
    government has set a price
    ceiling of $1,500 a month.
    The government’s price ceiling is shown by the solid yellow line. At the government’s
    price, 3,000 apartments are
    available, but consumers
    want 6,000. There is a shortage of 3,000 apartments.

    68

    Price per Apartment (dollars)

    Rent Controls

    e

    3,000

    1,500

    0

    D
    Shortage of 3,000 Apartments
    3,000

    Price Ceiling

    6,000

    Quantity of Apartments/year

    Part One / The Price System

    Now You Try It
    Using the following data, indicate what would happen if a price ceiling of $3 was imposed.
    Then what would happen if the price ceiling was raised to $7?
    Price
    Quantity Demanded
    Quantity Supplied

    $10

    9

    8

    7

    6

    5

    4

    3

    2

    1

    5

    10

    15

    20

    25

    30

    35

    40

    45

    50

    50

    45

    40

    35

    30

    25

    20

    15

    10

    5

    Had the government set the rent control price at $4,000 per month, the price
    ceiling would not have had an effect. Since the equilibrium is $3,000 a month, the
    price would not have risen to $4,000. Only if the price ceiling is below the equilibrium price will it be an effective price ceiling.
    Price ceilings are not uncommon features in the United States or in other
    economies. China had a severe housing shortage for 30 years because the price of
    housing was kept below equilibrium. Faced with unhappy citizens and realizing the
    cause of the shortage, officials began to lift the restrictions on housing prices in 1985.
    The shortage has diminished. In the former Soviet Union, prices on all goods and services were defined by the government. For most consumer items, the price was set
    below equilibrium; shortages existed. The long lines of people waiting to purchase
    food or clothing were the result of the price ceilings on all goods and services. In the
    United States, price ceilings on all goods and services have been imposed at times.
    During the First and Second World Wars and during the Nixon administration of the
    early 1970s, wage and price controls were imposed. These were price ceilings on
    goods and services. As a result of the ceilings, people were unable to purchase many
    of the products they desired. The Organization of Petroleum Exporting Countries
    (OPEC) restricted the quantity of oil in the early 1970s and drove its price up considerably. The U.S. government responded by placing a price ceiling on gasoline. The
    result was long lines at gas stations—shortages of gasoline.

    3.d. Price Floors: The Market for Agricultural Products
    price floor: a specific level
    below which price is not
    allowed to fall

    Price floors are quite common features in economies as well. A price floor is a certain level below which the price is not allowed to decrease. Consider Figure 13,
    which represents the market for sugar. The equilibrium price of sugar is $.10 a
    pound, but because the government has set a price floor of $.20 a pound, as shown
    by the solid yellow line, the price is not allowed to move to its equilibrium level. A
    surplus of 250,000 pounds of sugar results from the price floor. Sugar growers produce 1 million pounds of sugar, and consumers purchase 750,000 pounds of sugar.
    We saw previously that whenever the price is above the equilibrium price, market
    forces work to decrease the price. The price floor interferes with the functioning of
    the market; a surplus exists because the government will not allow the price to drop.
    How does the government ensure that the price floor remains in force? In the case of
    sugar, the government has to purchase the excess. The government must purchase
    the surplus so that its price floor of $.20 per pound remains in force.
    What would occur if the government had set the price floor at $.09 a pound?
    Since at $.09 a pound a shortage of sugar would result, the price would rise. A price
    floor only keeps the price from falling, not rising. So the price would rise to its
    equilibrium level of $.10. Only if the price floor is set above the equilibrium price
    is it an effective price floor.
    The agricultural policies of most of the developed nations are founded on
    price floors—the government’s guarantee that the price of an agricultural product
    will not fall below some level. Price floors result in surpluses, and this has been

    Chapter 3 / Applications of Demand and Supply

    69

    Figure 13

    Surplus of 250 Thousand Pounds

    A Price Floor

    S
    Price per Pound (dollars)

    The equilibrium price of sugar
    is $.10 a pound, but because
    the government has set a
    price floor of $.20 a pound, as
    shown by the solid yellow
    line, the price is not allowed
    to move to its equilibrium
    level. A surplus of 250,000
    pounds of sugar results from
    the price floor. Sugar growers
    produce 1 million pounds of
    sugar, and consumers purchase 750,000 pounds of
    sugar.

    Price Floor

    .20

    e

    .10

    D
    0

    750

    1,000

    Quantity of Sugar (thousands of pounds/year)

    Now You Try It
    The government does not allow
    sugar to fall below $.15 per
    pound. Illustrate the effect of
    this policy if the equilibrium
    price is $.10 per pound; if the
    equilibrium price is $.20 per
    pound.
    tariff: a tax imposed on goods
    and services purchased from
    foreign suppliers

    ?
    5. When the government

    intervenes in the
    market with a tariff,
    what is the result?

    70

    the case with many agricultural products. The surpluses in agricultural products in
    the United States have resulted in cases in which dairy farmers dumped milk in the
    river, in which grain was given to other nations at taxpayer expense, and in which
    citrus ranchers picked and then discarded thousands of tons of citrus, all to reduce
    huge surpluses.

    3.e. Tariffs
    We have seen how the government intervenes in the market by providing subsidies
    and setting price floors and price ceilings. Another way the government intervenes
    in the market is in the use of tariffs. A tariff is a tax on goods and services purchased from foreign suppliers. One of the tariffs the U.S. government imposes is on
    sugar. As we discussed previously, the U.S. government sets a price floor on sugar.
    In addition, U.S. imports are restricted by what is called a tariff-rate quota under
    which 40 quota-holding countries are each allocated a fixed amount of sugar that
    they may ship to the United States at a low tax rate; any sugar that enters above the
    quota is subject to a duty of 15.36 cents per pound. The total amount of sugar allowed to enter the United States at the low duty is 1.2 million tons, about 10 percent of U.S. sugar production.
    What is the effect of a tariff? Figure 14 illustrates the U.S. market for sugar. The
    demand accounts for all uses of sugar in foods and drinks. The supply consists of
    the total amount of sugar produced in the United States and the amount allowed in
    from other nations. In Figure 14 the U.S. price for sugar is $.20, the equilibrium
    price, and the equilibrium quantity is Q1. Now, contrast this with the result if there
    were no tariff. Without a tariff, the U.S. market for sugar would be no different than
    the world market. The result would be a hugely increased U.S. supply of sugar. The
    supply curve would shift out, thereby lowering price to about $.10—the world
    price.
    Who benefits from the tariff? Sugar producers. At the lower price, the U.S. sugar
    producers would reduce the quantities they produce because they would earn half as
    much as they do with the tariff. Who is harmed by the tariff? The U.S. consumers pay
    about twice as much for sugar as they would if there were no tariff, and sugar producers in other nations have much lower incomes because they are not allowed to sell as
    much sugar as they would like at a price they would like.

    Part One / The Price System

    Figure 14
    The U.S. Market for Sugar
    The demand for sugar consists of the demand for everything in which sugar is a component. The supply of sugar
    consists of the amount produced in the United States and
    the amount allowed to be shipped into the United States

    from other countries. The result is a price of $.20 per
    pound and a quantity Q1. Without the tariff, the supply in
    the United States would be much higher, “Supply without
    Tariff,” causing the equilibrium price to fall to about $.10
    per pound and the quantity to increase to Q2.

    Price of Sugar (dollars)

    Supply with Tariff

    Supply
    without Tariff

    .20

    .10
    Demand

    Q1

    Q2

    Quantity (amount of sugar/year)

    3.f. Quotas
    quota: a limit on the amount of
    a good that may be imported.

    Instead of placing a tax on imported goods or resources, a country will often place
    a quota on them. A quota allows only a limited quantity to be brought into the
    country. For instance, most nations have quotas on migration—only certain num-

    Here we see that a price floor
    leads to a surplus of blood oranges. The question is how to
    dispose of the surplus. In many
    nations the government purchases it. In Sicily, however, the
    least-cost solution may have
    been simply to dump the
    oranges.

    Chapter 3 / Applications of Demand and Supply

    71

    ?
    6. When the government

    restricts the quantity
    that can be sold, what
    occurs?

    bers of people can enter a country each year. Most nations also place quotas on
    some products. It is common to have quotas on agricultural products. For instance,
    the United States limits the amount of sugar that other nations may sell in the
    United States.
    To illustrate the effects of a quota, the U.S. market for sugar is shown in
    Figure 15. The supply of sugar in the United States consists of the quantities supplied by United States producers plus the quantities sent to the United States from
    other nations. In Figure 15, if there were no restrictions on price or quantity, the
    U.S. price would equal the world price of sugar, Pw . Now, what occurs when the
    United States places a quota on the sugar other nations can sell in the United
    States? A quota means less sugar will be supplied in the United States since other
    nations are restricted from shipping their sugar to the United States. The supply is
    less, so the supply curve shifts in. The smaller supply means a higher price. The
    more restrictive the quota, that is, the less the amount the quota allows to be
    shipped to the United States, the higher the U.S. price. The U.S. price is higher than
    the world price.

    3.g. Bans: The Ban on Trans Fats
    When something is outlawed, made illegal, it is banned or prohibited. For instance,
    many cities across the United States have banned smoking in public buildings, restaurants, or other places. A ban means there is no transaction of that item allowed. In
    2007, city and state legislators started looking at trans fats as something to legislate
    out of existence. Trans fats are formed when liquid oils are made into solid fats such
    as with partially hydrogenated vegetable oil, which is used for frying and baking and
    turns up in processed foods like cookies, pizza dough, and crackers. Trans fats, which
    are favored because of their long shelf life, are also found in pre-made blends like
    pancake and hot chocolate mix. The Food and Drug Administration estimates that the
    average American eats 4.7 pounds of trans fats each year. Trans fats have been found

    Figure 15

    Price

    The Effects of a Quota on
    the U.S. Market for Sugar
    Without restrictions on price
    or quantity, the U.S. price
    would equal the world price
    of sugar, Pw. When the United
    States places a quota on the
    sugar other nations can sell
    in the United States, the supply curve shifts in, since it is
    just the amount U.S. producers can supply plus the quota
    amount from the rest of the
    world. The U.S. sugar price is
    higher.

    Supply with Quota
    Supply

    Price in United States
    after Quota
    Price in United States
    and World (Pw )

    Demand

    Q with Quota Q
    Quantity of Sugar

    72

    Part One / The Price System

    Price

    Figure 16
    A Ban on Trans Fats

    Supply
    after Ban

    The ban on a certain type of
    cooking oil can affect the
    market for products that use
    this cooking oil. It raises the
    cost (reduces supply) and
    may alter demand (change
    tastes). The result of the ban
    is a higher price and a lower
    quantity.

    Supply

    Price
    after Ban
    Price

    Demand
    Demand
    after Ban
    Q after Ban

    Q

    Quantity of French Fries

    to be unhealthy, leading to heart disease. Some have claimed that trans fats contribute
    to tens of thousands of cases of heart disease each year.
    In 2007, New York City became the first U.S. city to ban the use of trans fats in
    restaurants. The restaurants weren’t able to simply substitute one ingredient for another. They had to overhaul recipes, change nationwide supply operations, and try
    to convince customers that the new French fries and doughnuts would taste just as
    good as the originals.
    If the ban eliminates the product altogether, then we don’t need to look at the
    market for trans fats—it has disappeared. But, what happens to the market for a
    food product that uses trans fats, such as French fries?
    The demand for and supply of French fries, as well as the equilibrium price and
    quantity, are shown in Figure 16. Now, what effect does the ban on trans fats have
    on this market? The restaurants have higher costs—finding new cooking oils that
    have the same taste and quality as those that create trans fats is expensive. This
    means that suppliers will offer any given quantity of French fries only at a higher
    price. The supply curve shifts in to “Supply after Ban.” Consumers, also, may react
    to the ban. They may not like the French fries as much after the ban. If this is the
    case, the demand would shift in to “Demand after Ban.” There is a possibility that
    demand might not shift in much or might actually shift out slightly if, as a result of
    being somewhat more healthy, some consumers purchase more French fries that
    they did when the fries were made with trans fats. The result, in this case, would be
    that the price of fries would be a little higher and the quantity of fries produced and
    sold a little less.

    R E C A P

    1. Every important event in our lives can be described by demand and
    supply; that is, it occurs within a market.
    2. The price of medical care has risen more rapidly than most goods and services over the past twenty years.

    Chapter 3 / Applications of Demand and Supply

    73

    3. More people are willing and able to buy medical care because of subsidies
    provided in the form of medicare and Medicaid. These programs allow people to purchase medical care even though they wouldn’t have the funds to
    pay for the care if it were not for the government subsidies.
    4. If it were allowed by government, a market for human organs would exist.
    There is a market for human organs, it is just that the government does not
    allow the buying and selling of organs.
    5. When the government does not allow a market to function, often a black
    market develops. A black market is a name for an illegal market.
    6. Another pervasive intervention in markets is the price ceiling—a limit on
    how high a price can go. The price ceiling leads to shortages and the use of
    alternative allocation mechanisms.
    7. Price floors are imposed quite often as well. In the agricultural area, it is
    quite common for the producers to be guaranteed a certain price for their
    products; the price cannot fall below that certain price. Price floors lead to
    surpluses.
    8. A tariff is a tax imposed on goods or services produced in another nation and
    sold domestically. The effect of a tariff is to raise the price of the foreignsupplied product. The result is higher domestic prices.
    9. A quota is a limit on the quantity of a good that can be supplied by one nation to another.
    10. A ban is a prohibition of the sale and consumption of a good or service. If
    effective, a ban may eliminate the market for the banned substance but raise
    the costs of other goods and services that relied on the banned substance.

    SUMMARY
    ?

    1.

    ?

    2.
    3.

    4.

    5.

    74

    In a market system, who determines what is
    produced?

    In a free market, that is, one not interfered with by
    the government, it is the consumers who decide what
    is produced. If the consumers switch their preferences from one item to another, producers will provide what the consumers are willing and able to
    pay for.

    ?

    6.

    7.

    Why do different people earn different incomes,
    and why do different jobs pay different wages?

    The labor market consists of the demand for and supply of labor.
    The wage rate and the quantities of workers employed are determined by the equilibrium between
    labor demand and labor supply.
    In reality, there are many different labor markets—
    markets for skilled versus unskilled labor, markets
    for dangerous versus non-dangerous jobs, and so on.
    An equilibrium wage differential or compensating
    wage differential exists when the equilibrium wage in
    two different labor markets is different.

    ?

    8.

    9.

    Why is illegal immigration an issue?

    Illegal immigration occurs because the government
    limits the number of people allowed to migrate into
    the country. Since legal entry is restricted, illegal entry is the only substitute for those who want to enter.
    Immigration occurs primarily because the opportunities available in the United States exceed those available in the home country. U.S. standards of living are
    several times higher than those in Mexico, for instance.
    When the government intervenes in the market
    by providing a subsidy, what is the result?

    The analysis of the market for medical care reveals
    that the reason for the rising costs is a rising demand.
    More people are willing and able to purchase more
    medical care than in the past. More people are willing
    because they are older and need more medical care.
    More people are able to purchase because government
    pays for a rising portion of the expenditures.
    Whenever a subsidy is provided to consumers, the
    demand for the subsidized good or service rises. The

    Part One / The Price System

    higher demand leads to increased quantities produced
    and higher prices than would have occurred without
    the subsidy.
    ?

    When the government intervenes in the market
    by setting a price floor or price ceiling, what is
    the result?

    10. A price ceiling is a limit on how high the price can be.
    If it is set below the equilibrium price, it creates a
    shortage.
    11. A price floor is a limit on how low the price can be.
    If it is set above the equilibrium price, it creates a
    surplus.
    ?

    When the government intervenes in the market
    with a tariff, what is the result?

    ?

    When the government restricts the quantity that
    can be sold, what occurs?

    13. The name for such a restriction is quota.
    14. A quota raises the price of the goods or service on
    which the quota has been placed.
    ?

    What is the effect of a ban on a good, service, or
    resource?

    15. A ban is a prohibition against the purchase or sale of a
    good or service. If effective, the market for that good
    or service is eliminated.
    16. Goods or services that used the banned item as an ingredient will have to be altered to use substitutes. The
    ban raises the cost of the good or service.

    12. A tariff is a tax on goods produced in another country
    and sold domestically. The tariff means higher prices.

    EXERCISES
    1.

    2.

    Using the schedule below define the equilibrium price
    and quantity. Describe the situation at a price of $10.
    What will occur? Describe the situation at a price of
    $2. What will occur?
    Suppose the government imposed a minimum price of
    $7 in the schedule of exercise 1. What would occur?
    Illustrate.

    Price

    Quantity
    Demanded

    Quantity
    Supplied

    $ 0
    2
    3
    4
    5
    6
    7
    8
    9
    10

    500
    400
    350
    320
    300
    275
    260
    230
    200
    150

    100
    120
    150
    200
    300
    410
    500
    650
    800
    975

    3.

    4.

    5.

    Using the data of exercise 1, indicate what the price
    would have to be to represent an effective price ceiling. Point out the surplus or shortage that results. Illustrate a price floor and provide an example of a
    price floor.
    A common feature of skiing is waiting in lift lines.
    Does the existence of lift lines mean that the price is
    not working to allocate the scarce resource? If so,
    what should be done about it?
    Many restaurants don’t take reservations. You simply
    arrive and wait your turn. If you arrive at 7:30 in the

    Chapter 3 / Applications of Demand and Supply

    evening, you have at least an hour wait. Notwithstanding that fact, a few people arrive, speak quietly
    with the maitre d’, hand him some money, and are
    promptly seated. At some restaurants that do take
    reservations, there is a month wait for a Saturday
    evening, three weeks for a Friday evening, two weeks
    for Tuesday through Thursday, and virtually no wait
    for Sunday or Monday evening. How do you explain
    these events using demand and supply?
    6. Give an example of a compensating wage differential
    in your community. What does it mean?
    7. The federal government is trying to change Medicare
    because it is too expensive. Yet many senior citizens
    are upset because the government is trying to change
    matters. Why would the senior citizens be upset? Using demand and supply, explain what would happen if
    the government reduced how much it would pay for
    medical care.
    8. Using demand and supply, illustrate the effects of a
    tariff imposed on foreign automobiles by the U.S.
    government.
    9. Using demand and supply, illustrate the effects of a
    quota imposed by the Canadian government on U.S.
    wheat. Show the U.S. wheat market and the Canadian
    wheat market.
    10 Using demand and supply, illustrate the effects of a
    ban on the use of steroids on the market for steroids. If
    people go to baseball games to see home runs, what
    will the ban do to the baseball market?

    75

    Internet
    Exercise

    76

    Use the Internet to find current information about U.S. labor markets.
    Go to the Boyes/Melvin, Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise link
    for Chapter 3. Now answer the questions that appear on the Boyes/Melvin website.

    Part One / The Price System

    Study Guide for Chapter 3
    ■ d. decrease in the quantity supplied of low-fat meals.
    ■ e. increase in the supply of low-carb foods.

    Key Term Match
    Match each term with its correct definition by placing
    the appropriate letter next to the corresponding number.
    A.
    B.
    C.
    D.

    compensating wage differential
    subsidy
    price ceiling
    price floor

    4

    Which of the following statements is false?
    ■ a. The demand for labor slopes down.
    ■ b. The supply of labor slopes up.
    ■ c. Younger workers earn higher wages than older
    workers.
    ■ d. Riskier jobs pay more than less risky jobs.
    ■ e. Males earn more than females.

    5

    Which statement is true?
    ■ a. The supply of workers in a less risky occupation
    is less than the supply of workers in a risky
    occupation.
    ■ b. The supply of workers in a less risky occupation
    is greater than the supply of workers in a risky
    occupation.
    ■ c. Firms will employ more people or hire people
    to work more hours as the wage rate increases.
    ■ d. Equilibrium-compensating wage differentials
    attract more workers from the less risky occupations to the risky ones.
    ■ e. The lower the hourly wage, the more hours that
    people are willing and able to work.

    6

    Which of the following caused the demand for health
    care to increase in recent years?
    ■ a. The percentage of elderly in the population is
    greater than before.
    ■ b. The cost of medical care has increased.
    ■ c. Government programs enable many people to
    get medical care without having to pay for it.
    ■ d. All of the above caused the demand for health
    care to increase in recent years.
    ■ e. Only a and c are reasons for the increase in the
    demand for health care in recent years.

    7

    A price ceiling
    ■ a. is a minimum price.
    ■ b. will cause a shortage if the ceiling is set above
    the equilibrium price.
    ■ c. will cause a shortage if the ceiling is set below
    the equilibrium price.
    ■ d. will cause a surplus if the ceiling is set above
    the equilibrium price.
    ■ e. will cause a surplus if the ceiling is set below
    the equilibrium price.

    E. tariff
    F. quota
    G. ban

    1. a situation in which the price is not allowed to
    rise above a certain level
    2. wage differences that make up for the higher risk
    or poorer working conditions of one job over
    another
    3. a tax on exports or imports
    4. payments made by government to encourage the
    production or purchase of a good
    5. a situation in which the price is not allowed to
    decrease below a certain level
    6. a restriction of supply
    7. a situation where buying or selling something is
    illegal

    Quick-Check Quiz
    1

    A change in tastes away from a good or service causes
    a(n)
    ■ a.
    ■ b.
    ■ c.
    ■ d.
    ■ e.

    2

    3

    in

    .

    increase; demand
    decrease; demand
    increase; supply
    decrease; supply
    increase; quantity supplied

    A decrease in demand results in a
    causing the equilibrium price to
    and the equilibrium quantity to
    ■ a. shortage; increase; increase
    ■ b. surplus; decrease; increase
    ■ c. shortage; increase; decrease
    ■ d. surplus; decrease; decrease
    ■ e. surplus; increase; decrease

    .

    The change in tastes away from low-fat meals initially
    resulted in a(n)
    ■ a. decrease in the demand for low-fat meals.
    ■ b. increase in the supply of low-fat meals.
    ■ c. increase in the quantity supplied of low-fat
    meals.

    Chapter 3 / Applications of Demand and Supply

    77

    8

    9

    A price floor
    ■ a. is a maximum price.
    ■ b. will cause a shortage if the floor is set above the
    equilibrium price.
    ■ c. will cause a shortage if the floor is set below the
    equilibrium price.
    ■ d. will cause a surplus if the floor is set above the
    equilibrium price.
    ■ e. will cause a surplus if the floor is set below the
    equilibrium price.

    8

    If a price ceiling is set above the equilibrium price,
    ■ a. a shortage will occur.
    ■ b. a surplus will occur.
    ■ c. the demand for the good or service will
    increase.
    ■ d. the supply for the good or service will increase.
    ■ e. the equilibrium price and quantity will prevail.

    10 Health care expenditures have increased so much

    The demand for labor slopes
    ,
    showing that the higher the price of labor, the
    (more, less) labor the firm
    will demand.

    9

    The supply of labor slopes
    ,
    showing that the higher the hourly wage, the
    hours people are willing to
    work.

    because the

    for health care

    services has increased relative to the
    11

    .

    and
    are government programs that pay for medical
    services.

    12 The emergence of Medicare and Medicaid in 1966

    Practice Questions and Problems

    caused the

    1

    In the market system, the
    ultimately determines what is to be produced.

    2

    The authority of consumers to determine what is produced through their purchases of goods and services
    is called

    3

    (demand, supply)

    for health care services to
    (increase, decrease).
    13 Because Medicare and Medicaid reduce the cost of

    purchasing health care, they are examples of

    .

    .

    Business firms respond to changes in consumers’ tastes
    because they want to make

    14 A price ceiling will cause a shortage only if it is set

    .

    (above, equal to, below) the
    equilibrium price.

    4

    When the demand for a good or service changes,
    resources move from an activity in which their value is
    relatively

    (above, equal to, below) the

    to an activity in which

    their value is relatively
    5

    15 A price floor will cause a surplus only if it is set

    equilibrium price.

    .

    In any labor market, the wage rate and number of
    jobs depend on the

    and

    16 A price ceiling will have no effect if it is set

    (above, equal to, below) the
    equilibrium price.

    curves for labor.
    17 If the U.S. government imposed a quota on Toyota
    6

    (Business firms, Households)
    demand labor.

    7

    (Business firms, Households)
    supply labor.

    78

    automobiles, it would

    (limit, expand) the

    (quantity, price) of Toyota automobiles that could be sold in the United States. The quota
    would have the effect of

    (increasing,

    Part One / The Price System

    reducing) the
    (demand for, supply of)
    automobiles other than Toyotas offered for sale in the
    United States.

    II

    18 If the U.S. government decided to impose a tariff on

    foreign-made televisions sold in the United States,
    you could predict that the tariff would
    (increase, decrease) the price
    of foreign-made
    televisions, which would

    (in-

    Wooden Bats Versus Metal Bats The supply of
    wooden bats is shown as Sw on the following graph. It
    has a steeper slope than the supply of metal bats, Sm,
    reflecting the fact that it is easier to produce additional metal bats than additional wooden bats.
    1. Assume Dm is the demand for metal bats. Suppose
    baseball purists are willing to pay more for a “sweet
    crack” sound than for a dull, metallic “ping” when
    they connect with a fastball. Draw a demand curve
    for wooden bats and label it Dw.

    crease, decrease) the
    (demand, supply) of foreign-made televisions, in turn
    Sw

    (increasing, decreasing) the
    price of foreign-made televisions and

    Sm

    Price

    (increasing, decreasing) the
    quantity of televisions brought into the United States.
    19 A ban on the use of copper in housing construction

    would have the effect of
    (increasing, decreasing) the price of copper. If
    nothing works as well as copper or can be used at
    the same cost as copper for housing construction,

    Dm
    Quantity

    then the ban would have the effect of
    (increasing decreasing) the cost of housing.)

    2. What are the consequences for the relative prices
    of wooden and metal bats?

    Exercises and Applications
    Price Controls and Medical Care As the price of
    health care rises, politicians may consider price controls on certain medical procedures to keep costs down.
    1. Would the price controls take the form of a price

    ceiling or a price floor?
    2. What do you think would happen in the market for
    these medical procedures if price controls were
    adopted?

    Chapter 3 / Applications of Demand and Supply



    ACE s

    I

    -test
    elf



    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    79

    Part Two

    Consumers, Firms, and Social Issues

    CHAPTER 4

    The Firm and the Consumer
    1. How do firms make money?
    2. What happens to sales when the price of a good or service changes?

    CHAPTER 5

    Costs and Profit Maximization
    1. What is the relationship between costs and output in the short run?
    2. What is economic profit?
    3. Why is profit maximized when MR = MC ?

    CHAPTER 6

    Competition
    1.
    2.
    3.
    4.

    CHAPTER 7

    Business, Society, and the Government
    1.
    2.
    3.
    4.
    5.

    CHAPTER 8

    What does free entry and competition mean?
    What is product differentiation?
    What are the benefits of competition?
    What is creative destruction?

    Why don’t people like market allocation?
    How do businesses attempt to interfere with market allocation?
    What are market failures?
    How might market failures be corrected?
    What are government failures?

    Social Issues
    1. What does economic analysis have to contribute to the understanding
    of environmental issues?
    2. Does the War on Drugs make economic sense?
    3. Does discrimination make economic sense?
    4. Does a minimum wage make economic sense?
    5. Why are incomes not equally distributed?
    6. What does it mean to be living in poverty?

    81

    Chapter 4

    ?

    Fundamental
    Questions

    1. How do firms make
    money?
    2. What happens to
    sales when the price
    of a good or service
    changes?

    The Firm and the Consumer

    T

    he owners of a business want that business
    to make a profit—to sell enough products at
    a high enough price that the firm can pay its
    costs and have some money remaining. In the next few chapters we examine how
    firms attempt to earn profits. We do this in three steps. The first step, taken in this
    chapter, is to discuss revenue. The second step is to examine costs, and the third
    step is to put revenue and costs together. After all, profit is revenue minus costs.
    The second and third steps are undertaken in the next chapter. ■

    Preview

    1. REVENUE
    total revenue: price times
    quantity sold (P  Q)

    ?
    1. How do firms make
    money?

    Firms earn revenue by selling goods and services to consumers. Total revenue
    is the price a product sells for multiplied by the number of units of the product
    that is sold (P × Q). How does a firm know the price to charge and the quantity
    to produce and offer for sale? It must know what the demand for its goods and
    services is. Demand is a relationship between price and quantity; demand tells
    the firm how much it could sell at each price. Thus, the firm would know what
    its revenue would be at each price if it knew what the demand for its goods and
    services was.

    1.a. Total, Average, and Marginal Revenue

    average revenue: per-unit
    revenue, total revenue
    divided by quantity

    AR =

    82

    TR P  Q
    =
    Q
    Q

    Let’s use the table in Figure 1 to discuss revenue for a bicycle store. Column 1 is
    the total quantity (Q) of bikes sold. Column 2 is price (P). If the price is $1,700,
    1 bike is sold. To sell 2 bikes, the store has to lower the price to $1,600. If the price
    is $1,500, 3 bikes are sold, and so on.
    Total revenue (TR) is found by multiplying the quantity of bikes sold by the
    price each bike is sold for. If only 1 bike is to be sold, the price is $1,700, and total
    revenue is $1,700. If 2 bikes are to be sold, the store must lower the price to $1,600
    apiece, and total revenue is $3,200. If 3 bikes are to be sold, then the price must be
    lowered to $1,500 apiece, and total revenue is $4,500.
    Columns 4 and 5 present two very useful pieces of information: average and
    marginal revenues. Average revenue (AR) is the per-unit revenue, the total revenue divided by the total number of bikes sold. Average revenue is listed in
    column 4. For the first bike, total revenue is $1,700, and average revenue is
    $1,700. For 2 bikes, total revenue is $3,200, and average revenue is $1,600. For
    3 bikes, total revenue is $4,500, and average revenue is $1,500.

    Part Two / Consumers, Firms, and Social Issues

    Figure 1
    (1)
    Total
    Quantity
    (Q)

    (2)
    Price
    (P)

    (3)
    Total
    Revenue
    (TR)

    (4)
    Average
    Revenue
    (AR)

    (5)
    Marginal
    Revenue
    (MR)

    1

    $1,700

    $1,700

    $1,700

    $1,700

    2

    1,600

    3,200

    1,600

    1,500

    3

    1,500

    4,500

    1,500

    1,300

    4

    1,400

    5,600

    1,400

    1,100

    5

    1,300

    6,500

    1,300

    900

    6

    1,200

    7,200

    1,200

    700

    7

    1,100

    7,700

    1,100

    500

    8

    1,000

    8,000

    1,000

    300

    9

    900

    8,100

    900

    100

    10

    800

    8,000

    800

    −100

    Average and Marginal Revenue
    The average-revenue (demand) and
    marginal-revenue curves are plotted
    here. As price declines, per-unit revenue
    (the average-revenue) declines.
    The downward-sloping marginalrevenue curve lies below the averagerevenue curve.

    2,000
    1,800
    1,600

    Price (dollars)

    1,400
    1,200
    1,000
    800

    Demand

    600
    400
    200
    0
    −100

    Marginal Revenue
    1

    2

    3

    4

    5

    6

    7

    8

    9

    10

    Quantity/year

    marginal revenue:
    incremental revenue, change
    in total revenue divided by
    change in quantity

    MR 

    change in TR
    change in Q

    You might have noticed that average revenue is just price: compare columns 2
    and 4 and you’ll see that they are the same. So demand is average revenue.
    Marginal revenue (MR) is the incremental revenue, the additional revenue
    from selling one more unit of output. Marginal revenue is listed in column 5. The
    marginal revenue of the first bike sold is the change in revenue that the firm receives for increasing its sales from 0 to 1 unit. When sold, the first bike brings
    in $1,700 in revenue, so the marginal revenue is $1,700. The marginal revenue
    of the second bike sold is the change in revenue that the firm receives for increasing its sales from 1 to 2 bikes. The second bike brings in an additional $1,500 in

    Chapter 4 / The Firm and the Consumer

    83

    Now You Try It
    If the price of a good or service
    is $10 per unit no matter how
    many units are sold, calculate
    average total revenue and marginal revenue at each quantity.

    R E C A P

    revenue, so the marginal revenue of the second bike is $1,500. The third bike brings
    in an additional $1,300 in revenue, so the marginal revenue of the third bike is
    $1,300.
    You may have wondered why a firm would care about its average or marginal
    revenue. It is because, as you’ll see in the next chapter, average and marginal revenues help determine the price to charge and the quantity to offer for sale.
    The average- and marginal-revenue schedules are plotted in Figure 1. The
    average-revenue (demand) curve slopes down, indicating that as the price declines,
    the per-unit revenue declines. The marginal-revenue curve also slopes down. It is
    steeper than the average-revenue curve and lies below it.

    1. Total revenue is the quantity sold multiplied by the price at which each unit
    sold.
    2. Average revenue (per-unit revenue) is the total revenue divided by the number of units sold.
    3. Marginal revenue is the incremental revenue, the additional revenue obtained
    by selling one more unit of output.
    4. Average revenue is the same as price.

    2. HOW DOES A FIRM LEARN ABOUT ITS DEMAND?
    Demand provides a great deal of information to a business and is something the
    firm has to know about. There are several ways that a business can learn about
    the demand for its goods and services. One approach you have probably run
    across is a survey. Polling organizations are hired by firms to ask consumers
    questions about demand. You may see the surveys conducted in malls where
    passersby are asked a series of questions about a product, or you may get a phone
    call—usually at dinner time—from a telemarketer.
    Another type of survey is called the focus group. A focus group usually consists
    of several randomly chosen shoppers who are paid to spend a few minutes completing questionnaires or answering questions.
    Another approach to obtaining information about demand is to use actual
    experience. A firm that has been in business for a period of time can use its actual
    experience to map out its demand—comparing past prices and quantities
    demanded, levels of income, number of customers, changes in the season, and so
    on. A new firm might have to rely on the experiences of other firms, using the
    prices and quantities demanded of a firm with a similar product that has been in
    business for a period of time. A firm offering a new product might do a test trial,
    introducing the product in just one city. This allows the firm to learn about the
    relationship between price and quantity demanded before it introduces the product
    nationwide.
    Many firms have instituted information retrieval or inventory control systems
    that record demand information on a continuous basis. Wal-Mart was one of the
    first firms to do this. Its scanning devices at the checkout register are connected
    to a computer that communicates with another computer at central headquarters.
    The system keeps track of sales and prices and orders more inventory when
    necessary.

    84

    Part Two / Consumers, Firms, and Social Issues

    2.a. Example: Demand for Auto Safety
    In the late 1980s, when auto companies were trying to decide whether to introduce
    air bags, they wondered how the bags would affect demand. For instance, GM argued that people would not pay more for a car with an air bag. The auto companies
    turned to consumer surveys to estimate the demand for the safety features. On the
    basis of a poll of 200 large fleet buyers, GM found that 33 percent were willing to
    buy the air bag only if the cost was $50 or less, an additional 28 percent were willing to pay as much as $100, and 19 percent more were willing to pay up to $150.
    Only 20 percent were willing to pay more than $200 for the air-bag option. As a
    result, GM offered the air bags on only 20 percent of its models.
    Ford, on the other hand, conducted a market experiment by introducing the air
    bags on one model but not on a similar model to see how consumers would respond.
    The higher price on the air-bag model did not affect sales as much as the GM survey
    indicated. As a result, Ford introduced the air bags on more models than GM did.

    2.b. Example: Demand for Oranges
    Researchers from the University of Florida examined the competition between California and Florida Valencia oranges. The researchers convinced nine supermarkets
    in Grand Rapids, Michigan, to vary the prices charged for Florida and California
    Valencia oranges daily for 31 days. More than 9,250 dozen oranges were sold during the time period. The researchers found that people preferred the Florida oranges but were very sensitive to price differences. A small price increase would
    cause consumers to purchase California rather than Florida Valencia oranges.

    2.c. Example: Location
    Researchers from Arizona State University and Harvard University investigated
    whether it made a difference in product sales whether the product was located
    near the front of the store in a display by itself or placed on shelves with other
    products. The researchers set up various displays and then introduced a select
    group of customers to the displays. The focus groups—the groups of potential
    customers—indicated that they would purchase more of the product when it was
    placed in a display by itself and the display was located near the front of the store
    than when it was located on shelves mixed in with other products.

    R E C A P

    1. Firms utilize several methods to gather information about their customers,
    that is, to learn about demand.
    2. Surveys, opinion polls, telemarketing, and focus groups all provide information related to what people say they will do in various circumstances.
    3. Actual data based on experience may be used to infer information
    about demand.
    4. Instantaneous information such as that provided by scanning devices connected to computers can provide useful information about demand.

    3. KNOWING THE CUSTOMER
    We’ve talked about how demand provides useful information to a business about
    revenue. But we’ve only touched the surface. Demand provides a great deal more information about revenue than we’ve discussed to this point.
    Chapter 4 / The Firm and the Consumer

    85

    Suppose you are in charge of setting the price of McDonald’s Big Mac. McDonald’s
    has not been doing well lately. Burger King has been grabbing more and more of
    the fast-food hamburger market. You have correctly reasoned that you should lower
    the price of the Big Mac to increase sales. The problem is you don’t know how
    much to lower it. Should the price be $.99 or $.85 or $.55? The answer depends on
    how consumers respond to the price change. Economists have devised a measure of
    how much consumers alter their purchases in response to price changes. This measure is called the price elasticity of demand.

    3.a. The Price Elasticity of Demand
    price elasticity of demand:
    the percentage change in
    quantity demanded divided
    by the percentage change
    in price

    The price elasticity of demand is a measure of the magnitude by which consumers
    alter the quantity of some product they purchase in response to a change in the price
    of that product. The more price-elastic demand is, the more responsive consumers are
    to a price change; that is, the more consumers will adjust their purchases of a product
    when the price of that product changes. Conversely, the less price-elastic demand is,
    the less responsive consumers are to a price change.
    The price elasticity of demand is defined as the percentage change in the quantity demanded of a product divided by the percentage change in the price of that
    product.
    ed 

    elastic: price elasticity
    greater than 1
    unit elastic: price elasticity
    equal to 1
    inelastic: price elasticity
    less than 1

    percentage change in quantity demanded
    percentage change in price

    Demand can be elastic, unit elastic, or inelastic. The price elasticity is always a
    negative number because when the price rises, the quantity demanded falls. Thus
    we typically ignore the negative sign and say that when the price elasticity of demand is greater than 1, demand is elastic. For instance, if the quantity of videotapes
    that are rented falls by 3 percent whenever the price of a videotape rental rises by
    1 percent, the price elasticity of demand for videotape rentals is 3.
    ed 

    3 percent
    3
    1 percent

    When the price elasticity of demand is 1, demand is said to be unit elastic. For example, if the price of private education rises by 1 percent and the quantity of private
    education purchased falls by about 1 percent, the price elasticity of demand is 1.
    ed 

    1 percent
    1
    1 percent

    In the past decade, U.S. consumers have increased their consumption of fish. The doubling
    of the amount of fish consumed
    has led to an expansion of the
    fish-producing industry. Most
    fish consumed are not caught in
    oceans or rivers but are grown
    on farms, such as this one in
    Caldwell, Idaho. Although fish is
    an important part of their diet,
    when the price of a type of fish
    rises, a small number of consumers switch to other types of
    fish or to beef, pork, or chicken.

    86

    Part Two / Consumers, Firms, and Social Issues

    Now You Try It
    What is the price elasticity
    of demand if the percent
    change in quantity demanded
    is 5 when price change is 20%?
    What is price elasticity of
    demand if percent change in
    quantity demanded is 20 when
    the price change is 5%?

    perfectly elastic: infinite
    price elasticity

    When the price elasticity of demand is less than 1, demand is said to be
    inelastic. In this case, a 1 percent rise in price brings forth a smaller than 1 percent
    decline in quantity demanded. For example, if the price of gasoline rises by
    1 percent and the quantity of gasoline purchased falls by 0.2 percent, the price
    elasticity of demand is 0.2.
    ed 

    0.2 percent
     0.2
    1 percent

    3.a.1. Price Elasticity and Shape of the Demand Curve The shape of a demand curve depends on the price elasticity of demand. A perfectly elastic demand
    curve is a horizontal line that shows that consumers can purchase any quantity they
    want at the single price (P1) shown in Figure 2(a). An example of a perfectly elastic
    demand might be the demand for disk drives in PCs. There are quite a few disk
    drive manufacturers, and the PC manufacturers do not care which drive they install
    in their machines; consumers have no idea which disk drive company produced
    their drives. As a result, if the price of one brand of disk drives is increased, the PC
    manufacturers are likely to move to another brand of disk drive. A perfectly elastic
    demand means that even the smallest price change will cause consumers to change
    their consumption by a huge amount, in fact, by totally switching purchases to the
    producer with the lowest prices.

    Figure 2(a)

    Figure 2(c)

    Perfectly Elastic Demand

    Alternative Demand Curves

    The quantity demanded varies from zero to infinity at
    the one price. Demand is so sensitive to price that even
    an infinitesimal change leads to a total change in quantity
    demanded.

    The curves D1 and D2 represent straight, downwardsloping demand curves. The curve D2 is said to be more
    elastic than D1 because at every single price the elasticity
    of demand is higher at D2 than at D1.

    Figure 2(b)
    Perfectly Inelastic Demand
    The quantity demanded is the same no matter what the
    price. Demand is completely insensitive to price.

    (a) Perfectly Elastic Demand Curve

    (b) Perfectly Inelastic Demand Curve

    (c) Alternative Demand Curves

    P1

    Price

    Price

    Price

    D2

    D1
    Quantity/time period

    Chapter 4 / The Firm and the Consumer

    Q1
    Quantity/time period

    Quantity/time period

    87

    perfectly inelastic: zero
    price elasticity

    ?
    2. What happens to sales
    when the price of a
    good or service
    changes?

    Now You Try It
    If the price elasticity of demand for movies at the local
    theater is 1.4, how could the
    movie theater increase its
    revenue?

    A perfectly inelastic demand curve is a vertical line, illustrating the idea that
    consumers cannot or will not change the quantity of a product they purchase when
    the price of the product is changed. Perhaps insulin to a diabetic person is a reasonably vivid example of a product whose demand is perfectly inelastic. The diabetic
    would pay almost any price to get the quantity (Q1) needed to remain healthy.
    Figure 2(b) shows a perfectly inelastic demand curve.
    In between the two extreme shapes of demand curves are the demand curves for
    most products. Figure 2(c) illustrates two demand curves. One is a relatively flat
    line (D2), and the other is a relatively steep line (D1). The curve D2 is said to be
    more price-elastic than D1.

    3.b. Price Elasticity and Revenue
    Why is the price elasticity of demand an important piece of information? It tells us
    how consumers will react to a price change. This means it also tells us what will
    happen to revenue as the price is increased or decreased.
    The price elasticity of demand tells us if a price change will increase or decrease
    revenue. We know that total revenue (TR) is the price of a product multiplied by the
    quantity sold: TR  P  Q. We also know that when the price goes up, the quantity
    demanded declines and vice versa. So whether total revenue increases or decreases
    when the price changes depends on which changes more, the price or the quantity
    demanded.
    If P rises by 10 percent, and Q falls by more than 10 percent, then total revenue
    declines as a result of the price rise. If P rises by 10 percent, and Q falls by less
    than 10 percent, then total revenue rises as a result of the price rise. If P increases
    by 10 percent, and Q falls by 10 percent, total revenue does not change as the
    price changes. Thus, total revenue increases as price is increased if demand is inelastic, decreases as price is increased if demand is elastic, and does not change
    as price is increased if demand is unit elastic.
    For example, if the price elasticity of demand for gasoline is 0.2, then a 10 percent increase in price, say from $1.20 per gallon to $1.32 per gallon, will result in a
    decline of quantity demanded by only 2 percent. Thus, total revenue will rise. As
    long as demand is inelastic, increasing the price raises revenue.
    On the other hand, if the price elasticity of demand is 2.0, such as is the case for
    video rentals, then a 10 percent increase in price, say from $1.99 to $2.19, will lead
    to a 20 percent reduction in quantity demanded. This means that total revenue will
    decline. As long as demand is elastic, increasing the price reduces revenue.
    Total revenue and price move in opposite directions when demand is elastic
    and in the same direction when demand is inelastic. When demand is elastic, a
    price rise leads to a decline in total revenue while a price decrease causes total revenue to rise. When demand is inelastic, a price rise leads to an increase in total
    revenue while a price decline leads to a decrease in total revenue. Thus, to increase
    revenue, a firm will increase price when demand is inelastic and reduce price when
    demand is elastic.
    3.b.1. Price Discrimination The relationship between the price elasticity of
    demand and revenue explains many things we observe in the real world.
    Not all consumers respond in the same way to a change in the price of a product.
    For instance, the demand for airline service by the business traveler is different
    from the demand by the tourist. The business traveler typically is on a tighter
    schedule than the tourist, so the tourist has many more flying options than the business traveler. This means that the demand by the business traveler is less priceelastic than the demand by the tourist.
    The airline can increase revenue by increasing price to the business traveler
    and lowering it to the tourist. (Increase price to increase revenue if demand is

    88

    Part Two / Consumers, Firms, and Social Issues

    price discrimination:
    different prices charged
    to different customers

    Now You Try It
    Golf courses often charge
    tourists more than residents
    and charge more during good
    weather months than during
    bad weather months. Why?

    price inelastic; decrease price to increase revenue if demand is price elastic.)
    It is for this reason that you find airlines offering substantial discounts for staying
    over a Saturday night or for purchasing tickets several weeks in advance. These
    policies, called price discrimination, distinguish the tourist from the business
    traveler.
    Price discrimination is a way to increase revenue by separating customers into
    groups according to the price elasticity of demand. Movie theaters separate customers into different groups—children, senior citizens, and others. Senior citizens’
    demand for movies has a higher price elasticity than the rest of the population’s demand for movies. Thus, the movie theater discriminates by charging a higher price
    to the rest of the population than it does to senior citizens. Children’s demand for
    movies also has a higher price elasticity, partly because their parents have to attend
    the movie with them, which raises the amount spent and thus the sensitivity to
    price.
    Warehouse-type stores, like Costco and Sam’s, cater to customers who are
    willing to purchase larger quantities of a product to get a lower price. Their
    demand for certain products has a higher price elasticity than that of those not
    willing to purchase in large quantities. In this case, firms lower their prices for
    large quantities of goods to attract the type of customer who cares less about
    ambiance or service than about lower prices.

    3.c. Determinants of Price Elasticity
    If you are going to use the price elasticity of demand to set the price on any good, you
    have to know what things influence that elasticity. In general:
    1. The more substitutes for a product, the higher the price elasticity of demand.
    2. The greater the importance of the product in the consumer’s total budget, the
    higher the price elasticity of demand.
    3. The longer the time period under consideration, the higher the price elasticity
    of demand.
    Consumers who can easily switch from one product to another without losing quality or some other attribute associated with the original product will be very sensitive to a price change. Their demand will be very elastic. A senior citizen discount

    Price Adjusting Vending Machines

    T

    he Coca-Cola Company tested
    a vending machine that can
    automatically raise prices for
    its drinks during hot weather. A
    temperature sensor and a computer
    chip altered the required change you
    needed to insert into the machine to
    get your can of Coke. The idea is
    based on price elasticity. If you want
    a coke when it is hot outside, you
    will pay more than if you purchase it
    when it is cool. The reason is that
    consumers are less sensitive to a
    price increase when it is hot—they

    Chapter 4 / The Firm and the Consumer

    Global Business Insight

    are thirstier. In cool
    Vancouver
    weather, they aren’t
    Dublin
    as thirsty and figure
    United
    States
    they can wait to get a
    Mexico
    City
    soda. Coca-Cola also
    considered adjusting
    prices based on the
    demand at a specific
    matchine. Prices could
    be discounted at a
    vending machine in a
    building during the evening or when
    not enthusiastic in the United States,
    there is less traffic. Reactions to the
    but such machines are in operation
    heat-sensitive Coke machine were
    in Japan.

    89

    The Coca-Cola brand is so well
    known around the world that it
    can be priced higher anywhere
    relative to competing sodas. It
    has been one of the five most
    recognized brands in the world
    for the past twenty years.

    is offered at movie theaters because senior citizens who are retired have many more
    substitutes than working people do. The retirees have more time to seek out alternative entertainment and to attend movies at different times. In contrast, business
    travelers have few substitutes for the times they need to travel; they have to take
    the airline at that time. As a result, their demands for airline seats are relatively
    inelastic.
    When there are fewer close substitutes for a product, the firm can increase the
    price without losing significant business and revenue. It is for this reason that
    firms attempt to create brand names and customer loyalty. Increasing brand name
    recognition and customer loyalty toward that brand means that fewer close
    substitutes exist and thus that the price elasticity of demand is lower. It is because
    of brand name recognition that Coca-Cola is priced higher than Safeway brand
    cola and Bayer aspirin is priced higher than Walgreen’s aspirin.
    The greater the portion of the consumer’s budget a good constitutes, the more
    price-elastic is the demand for the good. Because a new car and a European vacation are quite expensive, even a small percentage change in their prices can take a
    significant portion of a household’s income. As a result, a one percent increase in
    price may cause many households to delay the purchase of a car or vacation. Coffee,
    on the other hand, accounts for such a small portion of a household’s total weekly
    expenditures that a large percentage increase in the price of coffee will probably
    have little effect on the quantity of coffee purchased. The demand for vacations is
    usually more price-elastic than the demand for coffee.
    The longer the period under consideration, the more price-elastic is the demand
    for any product. The demand for most goods and services over a short period of
    time, say, a few hours or a few days, is less price-elastic. However, over a period of
    a year or several years, the demand for most products will be more price-elastic.
    For instance, the demand for gasoline is almost perfectly inelastic over a period of
    a month. No good substitutes are available in so brief a period. Over a ten-year period, however, the demand for gasoline is much more price-elastic. The additional
    time allows consumers to alter their behavior to make better use of gasoline and to
    find substitutes for gasoline.

    90

    Part Two / Consumers, Firms, and Social Issues

    1. The price elasticity of demand is a measure of how sensitive consumers are
    to price changes. An elastic demand is one for which a one percent change in
    price leads to a greater than one percent change in the quantity demanded. An
    inelastic demand is one for which a one percent change in price leads to a
    less than one percent change in quantity demanded.
    2. When demand is elastic, a one percent price decrease will lead to a greater
    than one percent increase in the quantity demanded. This means that total
    revenue rises when the price is decreased in the elastic region of demand.
    3. When demand is inelastic, a one percent decrease in price leads to a smaller
    than one percent increase in quantity demanded. As a result, total revenue declines whenever price is decreased in the inelastic region of a demand curve.
    4. Price discrimination is a pricing strategy whereby different customers are
    charged different prices for identical products. Price discrimination is based
    on different consumers having different price elasticities of demand. The customers with the higher price elasticities are charged lower prices than those
    with lower price elasticities.
    5. The determinants of the price elasticity of demand include the availability of
    substitutes, the cost of the good or service relative to income, and the time
    period being considered.

    R E C A P

    4. WHAT’S TO COME?
    Once a firm has information about the demand for its goods and services, it is part
    of the way toward knowing the price to charge and the quantities to produce and try
    to sell in order to earn a profit. From demand, a firm can determine revenue. But
    can it make a profit? To know this, a firm must have both demand information and
    cost information. We’ll turn to the cost information in the next chapter.
    What did you decide about the Big Mac? Are you lowering the price? How much?

    SUMMARY
    ?

    1.

    Total revenue is price times quantity sold.

    2.

    Marginal revenue is the incremental revenue that
    comes from increasing or decreasing the quantity of a
    good or service that is sold.

    3.

    Average revenue is per-unit revenue. It is the same
    thing as demand.

    4.

    Marginal revenue is less than average revenue. The
    marginal-revenue curve lies below the averagerevenue (demand) curve.

    ?

    5.

    manded of a good divided by the percentage change
    in the price of the good.

    How do firms make money?

    What happens to sales when the price of a good
    or service changes?

    The price elasticity of demand is a measure of the responsiveness of consumers to changes in price. It is
    defined as the percentage change in the quantity de-

    Chapter 4 / The Firm and the Consumer

    6.

    Demand is price-elastic when the price elasticity is
    greater than 1; it is price-inelastic when the price elasticity is less than 1; it is unit elastic when the price
    elasticity is 1.

    7.

    The price elasticity of demand is always a negative
    number because of the law of demand; when price
    goes up, quantity demanded goes down, and vice
    versa. As a result, we typically ignore the negative
    sign when speaking of the price elasticity of demand.

    8.

    If the price elasticity of demand is greater than 1, demand is price-elastic. In this case, total revenue and
    price changes move in opposite directions. An increase in price causes a decrease in total revenue, and
    vice versa. If demand is inelastic, then price changes
    and total revenue move in the same direction.

    91

    9.

    Firms use price elasticity to set prices. In some cases,
    a firm will charge different prices to different sets of
    customers for an identical product. This is called price
    discrimination.
    10. The greater the number of close substitutes, the
    greater the price elasticity of demand.

    11. The greater the proportion of a household’s budget a
    good constitutes, the greater the household’s price
    elasticity of demand for that good.
    12. The demand for most products over a longer time period has a greater price elasticity than the same product demand over a short time period.

    EXERCISES
    1.

    Use the table below to complete the following exercise. Plot the price and quantity data. Indicate the
    price elasticity value at each price. What happens to
    the elasticity value as you move down the demand
    curve?

    Price
    $5
    10
    15
    20
    25
    30

    % Change
    in Price

    100
    66
    33
    25
    20

    Quantity
    Demanded
    100
    80
    60
    40
    20
    0

    6.

    20
    25
    33
    50
    100

    Below the demand curve plotted in exercise 1, plot
    the total-revenue curve, measuring total revenue on
    the vertical axis and quantity on the horizontal axis.

    3.

    What would a 10 percent increase in the price of
    movie tickets mean for the revenue of a movie theater
    if the price elasticity of demand was, in turn, 0.1, 0.5,
    1.0, and 5.0?

    4.

    Suppose the price elasticity of demand for movies by
    teenagers is 0.2 and that by adults is 2.0. What policy

    92

    5.

    % Change
    in Quantity

    2.

    Internet
    Exercise

    would the movie theater implement to increase total
    revenue?

    7.

    Explain why senior citizens often obtain special
    price discounts.
    Using the following data, calculate total, average, and
    marginal revenues:
    Price

    Quantity Sold

    $100
    90
    80
    70
    60
    50
    40
    30
    20

    200
    250
    300
    350
    400
    450
    500
    550
    600

    In recent years, U.S. car manufacturers have charged
    lower car prices in western states in an effort to offset
    the competition by the Japanese cars. This two-tier
    pricing scheme has upset many car dealers in the
    eastern states. Many have called it discriminatory and
    illegal. Can you provide another explanation for the
    two-tier pricing scheme?

    Use the Internet to calculate point price elasticity on the About Economics website.
    Go to the Boyes/Melvin, Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e. and click on the Internet Exercise
    link for Chapter 4. Now answer the questions that appear on the Boyes/Melvin website.

    Part Two / Consumers, Firms, and Social Issues

    Study Guide for Chapter 4
    ■ a. decreases.
    ■ b. increases.
    ■ c. holds constant.

    Key Term Match
    Match each term with its correct definition by placing the appropriate letter next to the corresponding
    number.
    A.
    B.
    C.
    D.

    total revenue
    average revenue (AR)
    marginal revenue (MR)
    price elasticity of
    demand
    E. elastic demand

    4

    A business knows that it has two sets of customers,
    one of which has a much more elastic demand than
    the other. If the business uses price discrimination,
    which set of customers should receive a lower price?
    ■ a. Both sets should receive the same price.
    ■ b. It doesn’t matter to the business which gets a
    lower price.
    ■ c. The set with the more price elastic demand
    should receive a lower price.
    ■ d. The set with the less elastic demand should
    receive a lower price.

    5

    The price elasticity of demand for a product is largest
    when there
    ■ a. are no good substitutes for the product.
    ■ b. is only one good substitute for the product.
    ■ c. are two or three good substitutes for the
    product.
    ■ d. are many good substitutes for the product.

    6

    The price elasticity of demand for a product is largest
    when the
    ■ a. product constitutes a large portion of the consumer’s budget.
    ■ b. product constitutes a small portion of the consumer’s budget.
    ■ c. time period under consideration is very short.

    7

    The price elasticity of demand for a product is largest
    when the
    ■ a. time period under consideration is long.
    ■ b. time period under consideration is very short.
    ■ c. product constitutes a small portion of the consumer’s budget.

    8

    Suppose you are the city manager of a small Midwestern city. Your city-owned bus system is losing money,
    and you have to find a way to take in more revenue.
    Your staff recommends raising bus fares, but bus riders argue that reducing bus fares to attract new riders
    would increase revenue. You conclude that
    ■ a. your staff thinks that the demand for bus service
    is elastic whereas the bus riders think that demand is inelastic.
    ■ b. your staff thinks that the demand for bus service
    is inelastic whereas the bus riders think that demand is elastic.

    F. unit elastic demand
    G. inelastic demand
    H. perfectly elastic demand
    I. perfectly inelastic
    demand
    J. price discrimination

    1. incremental revenue, change in total revenue divided by change in quantity
    2. price elasticity greater than 1
    3. price times quantity sold
    4. price elasticity less than 1
    5. zero price elasticity
    6. price elasticity equal to 1
    7. per-unit revenue, total revenue divided by
    quantity
    8. different prices charged to different customers
    9. infinite price elasticity
    10. the percentage change in quantity demanded
    divided by the percentage change in price

    Quick-Check Quiz
    1

    One day while you are in a shopping mall, someone
    comes up to you and asks you questions about a
    product. What is the firm that is paying someone to
    ask the questions probably trying to get information
    about?

    ■ a. its supply
    ■ b. its demand
    ■ c. its production costs
    ■ d. the quality of its management
    ■ e. its negative revenue
    2

    What method for learning about demand for a product
    can only be used by a firm that has been making the
    product for a period of time?
    ■ a. shopping mall surveys
    ■ b. telephone surveys
    ■ c. the firm’s actual experience
    ■ d. doing a test trial in one or two cities
    ■ e. using focus groups

    3

    When price elasticity is greater than 1, total revenue
    increases if price

    Chapter 4 / The Firm and the Consumer

    93

    ■ c. both your staff and the bus riders think that the

    7

    demand for bus service is elastic.
    ■ d. both your staff and the bus riders think that the
    demand for bus service is inelastic.
    ■ e. both your staff and the bus riders think that the
    demand for bus service is unit elastic.
    9

    ed =

    Airlines know from experience that vacation travelers
    have an elastic demand for air travel whereas business travelers have an inelastic demand for air travel.
    If an airline wants to increase its total revenue, it
    should
    ■ a. decrease fares for both business and vacation
    travelers.
    ■ b. increase fares for both business and vacation
    travelers.
    ■ c. increase fares for business travelers and decrease fares for vacation travelers.
    ■ d. decrease fares for business travelers and increase fares for vacation travelers.
    ■ e. leave fares the same for both groups.

    The equation for calculating total revenue is
    .

    2

    The equation for calculating average revenue is

    The equation for calculating marginal revenue is
    .

    4

    percentage change in
    percentage change in

    Use the following demand schedule to calculate total
    revenue, average revenue, and marginal revenue.

    Price
    $5
    5
    5
    5

    Quantity
    1
    2
    3
    4

    Use the following demand schedule to calculate total
    revenue, average revenue, and marginal revenue. Be
    careful doing this one—remember the exact definition
    of marginal revenue.

    Quantity
    100
    200
    300
    400

    ed equals
    5

    Average revenue is the same as

    6

    Use the following demand schedule to calculate total
    revenue, average revenue, and marginal revenue.

    94

    Quantity
    1
    2
    3
    4

    Marginal
    Revenue

    Total
    Revenue

    Average
    Revenue

    Marginal
    Revenue

    10 percent change in the number of movie tickets sold,

    .

    Price
    $10
    9
    8
    7

    Average
    Revenue

    10 If a 5 percent change in the price of movies causes a

    Incremental revenue is another term for

    Total
    Revenue

    Total
    Revenue

    How does the relationship between price and marginal
    revenue differ between problem 6 and problem 8?

    Price
    $20
    18
    16
    14

    .
    3

    8

    9

    Practice Questions and Problems
    1

    The equation used to calculate the price elasticity of
    demand is

    Average
    Revenue

    .

    Marginal
    Revenue

    and demand is
    (elastic, inelastic, unit elastic).

    11 If a 6 percent change in the price of coffee causes a 3

    percent change in the quantity of coffee bought, ed
    equals
    and demand is
    (elastic, inelastic, unit elastic).
    12 If a 2 percent change in the price of wine causes

    a 2 percent change in the number of bottles of

    Part Two / Consumers, Firms, and Social Issues

    wine bought, ed equals

    and

    demand is
    unit elastic).

    to reduce consumption of the product. Several years
    ago, California increased its cigarette tax by $.25 a
    pack; by the next year, cigarette purchases in California had declined by 10 percent. For simplicity, assume that all of this decrease was caused by the price
    of cigarettes increasing $.25 as a result of the tax increase. Use this information to answer the following
    questions.

    (elastic, inelastic,

    13 If a 5 percent change in the price of heroin causes

    no change in the amount of heroin bought, ed
    equals

    and demand is

    1. Cigarettes back then cost $1 per pack before
    the tax increase and $1.25 after. The demand elasticity for cigarettes over this price range is

    (perfectly elastic, perfectly
    inelastic).
    14 Complete the following table.

    Demand
    Elasticity
    Elastic
    Elastic
    Inelastic
    Inelastic
    Unit elastic
    Unit elastic

    . Demand for this product

    Price
    Change
    Increase
    Decrease
    Increase
    Decrease
    Increase
    Decrease

    II

    15 A product with

    (many, few)
    good substitutes would have a more elastic demand
    than a product with
    few) good substitutes.

    16 The

    is
    (elastic, inelastic).
    2. Use the determinants of demand elasticity discussed in Section 3 of the chapter to explain why
    you would expect the demand for cigarettes to be
    inelastic.

    Effect on Total Revenue
    (Increase, Decrease,
    Unchanged)

    (many,

    demand for new cars is likely to be

    (more, less) elastic than the
    demand for new Chevrolet cars.
    17 A product that takes a

    (large,
    small) portion of a consumer’s budget has a more
    elastic demand than a product that takes a
    (large, small) portion.

    18 When consumers have a

    (long, short) time to react to price changes, demand
    is more elastic than when consumers have a
    (long, short) period of time
    to react.

    Price Discrimination in Airline Fares Several
    years ago Northwest Airlines cut fares 35 percent for
    summer travel. There were some restrictions:

    Travel must begin on or after May 27 and be
    completed by September 15.
    The nonrefundable tickets require 14-day advance purchase.
    Travelers must stay at their destination over a
    Saturday night.
    People taking a plane trip for a vacation usually can
    plan their trip far in advance and don’t mind spending
    a weekend at their vacation destination. Business travelers, on the other hand, frequently have to travel
    without much advance notice and want to be back
    home on weekends.
    1. The main customers for Northwest’s discounted
    tickets will be
    (business,
    vacation) travelers.
    2. Does Northwest think the demand for airline tickets for vacation travel is elastic, inelastic, or unit
    elastic? Explain your answer.

    Exercises and Applications
    I

    Taxing Tobacco According to the law of demand,
    taxes that increase the price of a product are expected

    Chapter 4 / The Firm and the Consumer

    95

    (business, vacation) travelers have a higher price elasticity of demand.

    96

    ✸✔

    ACE s

    3. Based on the restrictions it sets and the effects of those restrictions on business and vacation travelers, Northwest must think that

    -test
    elf

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    Part Two / Consumers, Firms, and Social Issues

    This page intentionally left blank

    Chapter 5

    ?

    Fundamental
    Questions

    1. What is the relationship between costs
    and output in the
    short run?
    2. What is economic
    profit?
    3. Why is profit maximized when
    MR = MC?

    Costs and Profit Maximization

    W

    e would all enjoy getting the things we
    purchase at lower prices. But a firm can’t
    supply goods and services for very long
    if it can’t sell them for at least what it costs the firm to supply them. A firm hires
    labor; purchases or leases equipment, buildings, and land; and acquires raw materials. What it pays for these resources are the firm’s costs. The firm must decide how
    many resources it needs and then what is the least costly way to acquire and use
    these resources. Once the firm figures out its costs, it can compare the costs with
    the revenues to see if it can make a profit.
    In this chapter, we first discuss costs, and then we combine costs and revenue to
    see how the firm earns a profit. ■

    Preview

    1. COSTS
    The costs of producing and selling goods and services are the costs of the resources
    used (i.e., the cost of land, labor, and capital). Total cost is C  Q—the cost of each
    quantity of output supplied multiplied by the quantity supplied.
    What happens to costs as the quantity of output rises? Since more resources are
    required to sell more output, it would seem logical that costs would rise as the
    quantity of output rises. This is the case; costs do rise as output rises, but each unit
    increase in output does not increase costs the same amount. As output rises unit by
    unit, costs rise relatively slowly at first but then increase more and more rapidly.
    The reason is that at first one additional resource can do a lot. For example, hiring
    another employee can allow the firm to deal with several more customers. But
    eventually it takes an increasing amount of additional resources to increase output
    another unit. With too many salespeople, each customer has to wait until his or her
    salesperson can get access to a cash register, for example.

    1.a. Total, Average, and Marginal Costs
    average total costs: per-unit
    costs, total costs divided by
    quantity

    ATC =

    98

    TC
    Q

    Let’s use the table in Figure 1 to discuss costs for the same bicycle store from
    Chapter 4. The costs for the bicycle firm, Pacific Bikes, to sell bicycles each week
    are shown. Column 1 lists the total quantity (Q) of output—the number of bikes
    offered for sale each week. Column 2 lists the total costs (TC) of providing each
    output level; it is the total cost schedule.
    Column 3 lists average total costs (ATC). Average total costs are derived by dividing the total costs by the quantity of output, in this case the number of bicycles.

    Part Two / Consumers, Firms, and Social Issues

    Figure 1
    Average Total and Marginal Costs
    look like those shown here. For every firm, as output rises,
    per-unit and incremental costs initially fall but eventually
    rise.

    The curves for average total and marginal costs in the
    short run are U-shaped. Every firm, no matter what it
    does and no matter what its size, has cost curves that

    2,000

    (2)
    Total
    Cost

    (Q)

    (TC)

    0

    1,000





    1

    2,000

    2,000

    2,000

    2

    2,800

    1,400

    800

    3

    3,500

    1,167

    700

    4

    4,000

    1,000

    500

    600

    5

    4,500

    900

    500

    400

    6

    5,200

    867

    700

    7

    6,000

    857

    800

    8

    7,000

    875

    1,000

    9

    9,000

    1,000

    2,000

    marginal costs: incremental
    costs, change in total costs
    divided by change in quantity

    MC =

    change in TC
    change in Q

    1,800

    Marginal
    Cost

    1,600

    (MC)

    1,400

    Price (dollars)

    (3)
    Average
    Total
    Cost
    (ATC)

    (4)
    Marginal
    Cost

    (1)
    Total
    Output

    1,200

    Average
    Total
    Cost

    1,000
    800

    200
    0

    1

    2

    3

    4

    5

    6

    7

    8

    9

    10

    Quantity/week

    Average total costs inform the manager what the costs of producing each unit of
    output are.
    Marginal costs (MC), the additional costs that come from selling an additional
    unit of output, are listed in column 4. Marginal costs are the incremental costs, the
    change in costs resulting from a small decline or increase in output. Marginal costs
    inform the manager whether the last unit of output offered for sale increased costs a
    huge amount, a small amount, or not at all.
    The average and marginal cost schedules are plotted in the graph in Figure 1.
    The ATC curve declines until 7 bicycles and then rises. The MC curve begins below
    the ATC curve and declines until 4 bicycles, stays the same for the 5th, and then begins to climb. The MC curve passes through the ATC curve at the minimum point
    of the ATC curve.

    Now You Try It
    Using the data, calculate average total cost and marginal cost at each quantity.
    Quantity
    Total Cost

    Chapter 5 / Costs and Profit Maximization

    100
    $2,000

    200
    $2,900

    300
    $3,700

    400
    $4,400

    500
    $5,000

    600
    $6,200

    99

    ?
    1. What is the relationship
    between costs and output in the short run?
    short run: a period of time
    just short enough so that at
    least one resource is fixed

    long run: period of time just
    long enough so that everything
    can be changed

    Table 1
    Output with Different
    Combinations of Resources

    100

    1.b. Why Are the Cost Curves U-Shaped?
    Both the curves for average and marginal costs are described as U-shaped; as
    output rises, per-unit and incremental costs initially fall but eventually rise. The
    shape of these curves is quite important because every firm, no matter what it does
    and no matter what its size, has cost curves that look like those in Figure 1 in
    the short run. The short run is a period of time just short enough so that at least
    one of the resources can’t be changed. How long is this? It depends on the type of
    business. An airline may have year-long leases on equipment and year-long contracts with employees. In such a case, the short run would be anything less than one
    year. A basket weaver may have no leases and may be able to alter all of its resources within a week’s time. In this case, the short run would be anything less than
    one week.
    It is important to distinguish between the short run and the long run. The long
    run is a period of time just long enough so that everything can be changed.
    In the short run, the firm has fewer options. It cannot expand or contract its entire
    operation. It can change only some of its resources, the resources referred to as
    variable. For instance, for the bike shop, the number of employees can be changed
    quite readily, probably within a day or two. But it would take a long time to
    change the size of the building and the number of cash registers, display areas, and
    repair stations. It is this fact that gives us the U-shaped cost curves. To understand
    why, let’s look more closely at the operations of the bicycle shop.
    The number of bicycles that can be assembled or repaired and then offered for
    sale during one week is shown in Table 1. One employee can put together and sell 3
    bicycles if the bike store has 1 station for assembling the bikes, 10 bicycles if the
    bike store has 2 repair stations, 25 bicycles if the bike store has 3 stations, and so
    on. With a second employee, output is increased with each quantity of repair stations: 2 employees and 1 repair station now generate 6 bicycles, and so on.
    In the long run every possible combination is an option for the firm. But suppose
    that Pacific Bikes had previously constructed one repair station and cannot change
    the number for at least a year. The firm is operating in the short run because it cannot change the size of the building or the number of repair stations. In this case, the
    number of repair stations is the fixed resource. The options open to Pacific Bikes in
    the short run are only those under column 1. Pacific Bikes can vary the number of
    employees but not the number of repair stations in the short run.
    As the first units of the variable resource (employees) are hired, each additional
    employee can prepare and sell many bicycles. But after a time, there are too many

    Number of
    Employees

    1

    Capital (number of repair stations and cash registers)
    2
    3
    4
    5
    6
    7

    0

    0

    0

    0

    0

    0

    0

    0

    1

    3

    10

    25

    34

    41

    40

    39

    2

    6

    25

    36

    45

    52

    53

    50

    3

    10

    36

    48

    57

    61

    62

    61

    4

    13

    44

    58

    64

    69

    70

    69

    5

    13

    50

    65

    71

    76

    77

    77

    6

    11

    54

    70

    76

    80

    82

    84

    7

    10

    55

    72

    79

    82

    85

    89

    8

    8

    54

    68

    80

    83

    86

    90

    Part Two / Consumers, Firms, and Social Issues

    law of diminishing marginal
    returns: as the quantity of a
    variable resource is increased,
    output initially rises rapidly,
    then more slowly, and
    eventually may decline

    Now You Try It
    Explain how adding more and
    more air bags to automobiles
    illustrates the law of diminishing marginal returns.

    employees in the store (“too many chefs stirring the broth”), and each additional employee adds only a little to total bicycles offered for sale. If the employees must
    stand around waiting for tools or room to work on the bikes, then an additional employee will allow few, if any, additional bicycles to be repaired or assembled and
    sold. Eventually, adding another employee may actually detract from the productivity of the existing employees as they bump into each other and mix their tools
    up. The limited capacity of the fixed resources—the number of repair stations, repair stands, cash registers, and building space—causes the efficiency of the variable resource—the employees—to decline.
    This relationship between quantities of a variable resource and quantities of
    output is called the law of diminishing marginal returns. According to the law of
    diminishing marginal returns, when successive equal amounts of a variable resource are combined with a fixed amount of another resource, output will initially
    increase rapidly, then increase more slowly, and eventually decline. Looking at
    Table 1, you can see the law of diminishing marginal returns at each quantity of repair stations. Just increase the number of employees for any given quantity of repair stations and output will rise rapidly at first, but then more slowly. Similarly, if
    the number of employees is fixed, and the number of repair stations is variable, you
    would also observe the law of diminishing marginal returns. With 1 employee, for
    instance, as the number of repair stations is increased, output rises from 30 to 100
    to 250 to 340, and so on. The first increases are large, but output rises less rapidly
    and eventually declines as the number of repair stations is increased.
    Diminishing marginal returns is not unique to the bicycle industry. In
    every instance in which increasing amounts of one resource are combined with
    fixed amounts of other resources, the additional output initially increases but eventually decreases. A classic example is putting increasing amounts of water on a potted plant. Initially the water helps the plant grow. Eventually, the water drowns the
    plant.
    The law of diminishing marginal returns also applies to studying. During the first
    hour you study a subject, you probably get a great deal of information. During the
    second hour you may also learn a large amount of new material, but eventually another hour of studying will provide no benefits and could be counterproductive.

    The bicycle shop has limited
    space; it has a showroom and
    a few stands at which the bikes
    can be repaired. If the number of
    bikes to be worked on increases
    and the number of workers increases, but the number of repair
    stands remains fixed, then the
    number of repaired bikes will rise
    as the number of workers rises
    but only up to a point. Beyond
    some point, the workers will
    interfere with each other, which
    may actually reduce the number
    of bikes repaired each hour.

    Chapter 5 / Costs and Profit Maximization

    101

    Every firm (and every individual and nation as well) is faced with the
    law of diminishing marginal returns. The law is, in fact, a physical property,
    something that is inescapable. It is important in economics because it defines the
    relationship between costs and output in the short run for every firm no matter
    what the firm does, no matter how large the firm is, no matter where the firm is
    located. For every firm, as it increases the amount of a variable resource it uses
    along with a fixed resource, the firm is able to get a great deal of additional output initially, but eventually the additional output increases more slowly and may
    actually decline. And since the firm has to pay for each employee or each unit of
    variable resource, its costs rise slowly at first as output increases, but then they
    rise more and more rapidly as output rises. This fact gives us the U shape of the
    average-total- and marginal-cost curves.

    1. Average total costs (ATC) are total costs divided by the total quantity of the
    good offered for sale (Q). Average total costs are per-unit costs.
    ATC 

    total costs
    quantity of output

    2. Marginal costs (MC) are the incremental costs that come from producing one
    more or one less unit of output:
    MC 
    R E C A P

    change in total costs
    change in quantity of output

    3. The short run is a period of time just short enough so that at least one of the
    resources is fixed. The long run is a period of time just long enough so that
    everything can be changed.
    4. The law of diminishing marginal returns applies only to the short run as variable resources are combined with a fixed resource.
    5. According to the law of diminishing marginal returns, as successive units of
    a variable resource are added to the fixed resources, the additional output will
    initially rise but will eventually decline.
    6. Diminishing marginal returns occur because the efficiency of variable resources depends on the quantity of the fixed resources.
    7. The law of diminishing marginal returns results in the U-shaped curves of average total and marginal costs.

    2. MAXIMIZING PROFIT
    Suppose I open a coffee shop at a nice location near the school. I purchase beans and
    equipment, and rent the building. I set up a nice surround-sound system, I have comfortable seating installed, and subscribe to wireless Internet and provide it to customers. Once these costs are factored in, I figure that it costs me $.70 to supply a cup
    of coffee. But that $.70 does not pay me anything for the money I used to start the
    coffee shop or for the time I devote to working in the shop. I figure that it takes $.10
    per cup to compensate me for the money I put into the business to get it started and
    for the time I put into the business each day. I sell the cup of coffee for $1.50, so I am
    enjoying a profit of $1.50 – $.80 = $.70 on each cup of coffee. The profit is great, but
    it also looks great to others. It is not very difficult to do what I am doing; as a result,
    someone else locates nearby and begins offering coffee for $1.40. Then still another

    102

    Part Two / Consumers, Firms, and Social Issues

    ?
    2. What is economic
    profit?

    begins selling coffee at $1.20 per cup. The process of people entering the business
    continues until the price is driven down to where it just covers all costs, $.80. At $.80
    per cup, no one has an incentive to enter and bid prices lower.
    This is the process of competition. A business starts, earns profits that exceed all
    costs, including the costs of the owner’s time and investments, and this attracts competitors. The competitors bid the price down until there is no more incentive for new
    businesses to start.

    2.a. Economic Profit

    economic profit: revenue
    less all costs, including the
    opportunity cost of the
    owner’s capital

    zero economic profit: revenue
    just pays all opportunity costs

    positive economic profit:
    revenue exceeds all
    opportunity costs

    negative economic profit:
    revenue does not pay for all
    opportunity costs

    normal profit: zero economic
    profit

    Why would the price be bid down to $.80, rather than $.70 or $1.00? If the price of
    the coffee was bid down to $.70, it would mean that the owner was not being fully
    compensated for the money or time he put into the company. This says he would be
    better off doing something else. For instance, suppose $50,000 is required to start
    the business and suppose that the owner could earn 5 percent using the money elsewhere. Then, rather than investing in the company, the owner could have earned
    5 percent on the $50,000, or $2,500 per year, by putting the money in a savings
    account or some other investment. Not earning that $2,500 is a cost, an opportunity
    cost of the owner’s money. Similarly, if the owner gave up a job where he earned
    $60,000 a year to work in the coffee shop, then that is a cost, an opportunity cost.
    The coffee shop needs to pay the owner $60,000 to fully compensate him for his
    time. If he could only get $40,000, the owner would actually be taking a loss of
    $20,000. He would be pulling out $40,000 but could have been getting $60,000 at
    his old job. Economic profit is total revenue less all opportunity costs, including
    the owner’s time and money.
    2.a.1. Zero Economic Profit Suppose the coffee shop ends up selling coffee
    for $.80 per cup. The owner is being fully compensated, but not getting anything
    more than his opportunity costs. When revenue is equal to total opportunity costs,
    economic profit is zero. Zero economic profit says that all opportunity costs are
    being paid—there is no alternative that will do better. The owners have no reason to
    sell their equity or to get out of the business. Similarly, there is no incentive for new
    competitors to enter the business.
    2.a.2. Positive Economic Profit If the price of the coffee is $1 per cup, it
    would mean that the firm is covering all opportunity costs and having $.20 per cup
    left over. The coffee shop would be earning positive economic profit, which
    means the owner could not expect to earn as much using the money in any other
    way. The owner is not only getting more than 5 percent on his $50,000 investment,
    but he is also taking more than $60,000 out of the business. The owner is earning
    more than his opportunity costs. This sends a signal to others that perhaps they too
    could earn more than their costs. More competitors would enter the business, increasing supply and driving price down.
    2.a.3. Negative Economic Profit When a firm does not earn enough revenue
    to pay all of its opportunity costs, we say the firm is earning negative economic
    profit. Negative economic profit means that the resources used in the business
    would have a higher value in another use. A firm that earns a negative economic
    profit for a long time will eventually go out of business.
    2.a.4. Normal Profit When firms can enter a business and freely compete with
    existing businesses, economic profit will eventually be driven to zero. Accountants
    refer to zero economic profit as normal profit. It is the return owners can expect to
    earn once competition has driven price to its lowest possible level.

    Chapter 5 / Costs and Profit Maximization

    103

    1.
    2.
    3.
    4.
    R E C A P

    Economic profit is Total revenue – total opportunity costs.
    Total costs = cost of land + cost of labor + cost of capital (debt + equity).
    Economic profit can be positive, zero, or negative.
    Positive economic profit means that revenue exceeds all opportunity costs.
    Owners could not do better investing in any other business. Other investors
    look at the possibility of also doing better than what they are currently doing
    and enter the business.
    5. Negative economic profit means that revenue is less than total opportunity
    costs. Owners would be better off using their resources in some other way.
    6. Zero economic profit means that revenue is equal to total opportunity costs.
    7. The accounting name for zero economic profit is normal profit.

    3. THE PROFIT-MAXIMIZING RULE: MR = MC
    ?
    3. Why is profit maximized
    when MR = MC?

    The goal of a for-profit firm is to earn the most profit it can, to maximize profit.
    The firm has to select a price to charge and determine how much it needs to sell in
    order to maximize profit. How does it do this? The economic rule defining what to
    do is a basic one, no different from the way you decide how much to eat for lunch.
    You eat another bite as long as that bite gives you more enjoyment than misery.
    When you have eaten enough that one more bite would actually cause you more
    misery than enjoyment, you stop eating. For a firm attempting to maximize profit,
    the firm sells one more unit of its goods or services as long as the additional revenue obtained exceeds the additional cost of supplying and selling that last unit of a
    good or service.

    3.a. Graphical Derivation of the MR = MC Rule
    Profit is maximized at the price and quantity at which MR  MC. Marginal costs
    are the additional costs of producing one more unit of output. Marginal revenue is

    Wal-Mart Supercenter is the
    company’s entry into the
    grocery business. The stores
    carry everything a regular WalMart does, and also stock a full
    line of groceries. Wal-Mart’s
    success with its original business
    model has been so remarkable
    that many other firms have tried
    to copy its behavior. The inventory control system that gave
    Wal-Mart its original advantage
    has been mimicked industrywide, and competitive forces
    have eroded the positive
    economic profits gained from
    it. However, Wal-Mart continues
    to seek and find other
    comparative advantages.

    104

    Part Two / Consumers, Firms, and Social Issues

    fixed costs: costs of fixed
    resources; costs that do not
    change as output changes
    variable costs: costs that vary
    as output varies

    the additional revenue obtained from selling one more unit of output. If the production of one more unit of output increases costs less than it increases revenue—that
    is, if marginal costs are less than marginal revenue—then producing (and selling)
    that unit of output will increase profit. Conversely, if the production of one more
    unit of output costs more than the revenue obtained from the sale of that unit, then
    producing that unit of output will decrease profit. When marginal revenue
    is greater than marginal cost, producing more will increase profit. Conversely,
    when marginal revenue is less than marginal cost, producing more will lower
    profit. Thus, profit is at a maximum when marginal revenue equals marginal cost:
    MR  MC.
    Consider Figure 2, in which the curves of average total and marginal cost from
    Figure 1 are drawn along with the curves of demand and marginal revenue from the
    previous chapter. Figure 2 illustrates the fundamental decisions made by all business managers and owners. The profit-maximizing rule, MR  MC, is illustrated in
    the table of Figure 2, which lists output, total revenue, total costs, marginal revenue, marginal cost, and profit for Pacific Bikes. The first column is the total quantity (Q) of bikes sold. Column 2 is the price (P) of each bike. Column 3 is the total
    revenue (TR) generated by selling each quantity. Column 4 is average revenue (AR)
    (which is the same as demand)—total revenue divided by quantity. Column 5 lists
    marginal revenue (MR)—the change in total revenue that comes with the sale of an
    additional bike.
    Total costs (TC) are listed in column 6. You might note that costs are $1,000
    even when no bikes are sold. Costs that have to be paid even when production is
    zero are called fixed costs. Fixed costs are items like the lease on the building and
    the payment on the loans used to construct repair stations. Other costs, referred to
    as variable costs, change as output changes. Variable costs include the costs of
    employees, electricity, water, and materials—items that change as quantity
    changes.
    Average total cost (ATC) is listed in column 7; it is total cost divided by quantity.
    Marginal cost (MC), the additional cost of selling an additional bike, is listed in column 8. The marginal cost of the first bike is the additional cost of offering the first
    bike for sale, $1,000; the marginal cost of the second bike is the increase in costs that
    results from offering a second bike for sale, $800. Total profit, the difference between
    total revenue and total costs (TR  TC), is listed in the last column.
    The first bike costs an additional $1,000 to sell; the marginal cost (additional cost)
    of the first bike is $1,000. When sold, the bike brings in $1,700 in revenue, so the
    marginal revenue is $1,700. Since marginal revenue is greater than marginal cost, the
    firm is better off selling that first bike than not selling it.
    The second bike costs an additional $800 (column 8) to sell and brings in an additional $1,500 (column 5) in revenue when sold. With the second bike, marginal
    revenue exceeds marginal cost. Thus, the firm is better off producing two bikes
    than none or one.
    Profit continues to rise until the sixth bike is sold. The marginal cost of selling
    the seventh bike is $800 while the marginal revenue is $500. Thus, marginal cost is
    greater than marginal revenue. Profit declines if the seventh bike is sold. The firm
    can maximize profit by selling six bikes, the quantity at which marginal revenue
    and marginal cost are equal.
    We can easily find the profit-maximizing price and quantity in Figure 2. Profit is
    maximized at the point at which MR  MC. The quantity the firm should sell to
    maximize profit is given by dropping a line down to the horizontal axis from the
    MR  MC point, a quantity of Q*  6. The price that the firm should charge to sell
    this quantity is given by extending the vertical line from the MR  MC point up to
    the demand curve. The demand curve tells us how much consumers are willing and
    able to pay for the quantity Q*. Then, we draw a horizontal line over to the vertical
    axis, the price axis, at P*  $1,200.

    Chapter 5 / Costs and Profit Maximization

    105

    Figure 2
    Revenue, Costs, and Profit
    is not. When marginal revenue is less than marginal cost,
    there is more output and profit is reduced.

    When marginal revenue is greater than marginal cost,
    there is less output and some profit that could be earned
    (1)
    Total
    Output

    (2)
    Price

    (3)
    Total
    Revenue

    (4)
    Average
    Revenue

    (5)
    Marginal
    Revenue

    (6)
    Total
    Cost

    (Q)

    (P)

    (TR)

    (AR)

    (MR)

    (8)
    Marginal
    Cost

    (9)
    Total
    Profit

    (TC)

    (7)
    Average
    Total
    Cost
    (ATC)

    (MC)

    (TR – TC)

    0

    0

    0

    0

    0

    $1,000





    −$1,000

    1

    $1,700

    1,700

    1,700

    1,700

    2,000

    2,000

    2,000

    −300

    2

    1,600

    3,200

    1,600

    1,500

    2,800

    1,400

    800

    400

    3

    1,500

    4,500

    1,500

    1,300

    3,500

    1,167

    700

    1,000

    4

    1,400

    5,600

    1,400

    1,100

    4,000

    1,000

    500

    1,600

    5

    1,300

    6,500

    1,300

    900

    4,500

    900

    500

    2,000

    6

    1,200

    7,200

    1,200

    700

    5,200

    867

    700

    2,000

    7

    1,100

    7,700

    1,100

    500

    6,000

    857

    800

    1,700

    8

    1,000

    8,000

    1,000

    300

    7,000

    875

    1,000

    1,000

    9

    900

    8,100

    900

    100

    9,000

    1,000

    2,000

    −900

    Profit Maximum

    2,000

    Marginal Cost

    1,800
    1,600

    Price (dollars)

    1,400
    1,200

    P*

    C

    1,000

    Average Total Cost

    D
    Demand

    800
    600
    400
    200
    0

    Marginal Revenue

    Q*
    1

    2

    3

    4

    5

    6

    7

    8

    9

    10

    Quantity/week

    Now You Try It
    Using Figure 2, find the
    profit-maximizing output level
    if price is a constant $800 no
    matter how many units are
    sold.

    106

    Total revenue is given by the rectangle 06CP*. The total cost is found by multiplying average total cost by quantity. We draw a vertical line from Q*  6 up to the
    average-total-cost curve; it intersects at point D. This gives us the per-unit costs of
    selling six bikes. We then draw a horizontal line over to the vertical axis; this represents multiplying ATC by Q*  6. The resulting rectangle 06D$867 is the total
    cost. Total profit, then, is the difference between total revenue and total cost. Total
    profit is given by the rectangle $867DCP*.

    Part Two / Consumers, Firms, and Social Issues

    Figure 2 provides a great deal of information about business behavior. The demand curve may be different (steeper or flatter) depending on the price elasticity of
    demand, or the position of the cost curves might be different depending on cost
    conditions; but irrespective, profit is maximized when MR  MC. Every decision a
    manager or owner makes comes down to comparing marginal revenue and marginal cost. Should the firm increase advertising expenditures? If the MR from doing
    so is greater than the MC, then yes. Should the firm hire another employee? If the
    MR from doing so exceeds the MC, then yes. This decision-making approach
    shouldn’t be any surprise to you. It is how you make decisions as well. You compare your marginal revenue (your additional benefits) of doing something to your
    marginal costs. If your marginal revenue exceeds your marginal cost, you do it.
    Nike used to have a slogan, “Just Do It.” What they ought to have said is, “If MR
    exceeds MC, then do it.”

    Now You Try It
    Substitute the following into Figure 2 and calculate marginal revenue and marginal cost.
    Quantity
    Price

    0

    1

    2

    3

    4

    5

    6

    7

    8

    9

    $2,400 $2,300 $2,200 $2,100 $2,000 $1,900 $1,800 $1,700 $1,600 $1,500

    3.b. What Have We Learned?
    We have covered a great deal of territory. We have learned how firms select the
    price to charge and quantity to sell to maximize profit. A firm will supply the quantity and charge a price given by the point at which MR  MC. Marginal revenue
    depends on demand, that is, on consumers. The firm must know what the consumer
    likes and what prices the consumer is willing and able to pay. It must supply its
    goods and services at those prices if it is to maximize its profit.
    For-profit firms behave so as to maximize profit and thus sell a quantity and set
    a price determined by the point at which MR  MC. So if we know marginal revenue and marginal cost, determining the quantity to sell and the price to charge is
    trivial. The problem is that marginal revenue and marginal cost are typically not
    known. All opportunity costs are not reported in accounting statements. Moreover,
    accountants allocate costs among activities or across departments; they do not calculate the incremental cost of producing one more unit or the incremental revenue
    from selling one more unit. As a result, it is often said that marginal cost and marginal revenue are not really useful. Why, then, do we pay so much attention to the
    rule MR  MC?
    Although accountants do not provide marginal cost information and although
    executives say they pay no attention to marginal cost or marginal revenue, these
    concepts are critical aspects of their decision making. Consider, for instance, how
    an airline decides to price its services. The price of seats varies considerably depending on the time one flies, whether a Saturday night stay occurs, and when one
    purchases a ticket. Often an airline flying with some empty seats will sell the seats
    at the last moment very inexpensively. In fact, the price of the seat is often below
    the average cost of flying the plane. The average total cost (per passenger cost) for
    Southwest Airlines is about $.07 per mile. Yet Southwest will often sell some of its
    seats on distances of 1,000 miles for $25. Why? Because $25 is significantly more
    than $0. The marginal cost of adding one more passenger is nearly zero. Thus, the
    additional (marginal) revenue of the seat, $25, is greater than the marginal cost.
    The executives of Southwest know that they are better off selling the seat than not

    Chapter 5 / Costs and Profit Maximization

    107

    selling it. They know this not because they have calculated marginal revenue and
    marginal cost but because they know they make more profit by doing so. The
    profit-maximizing rule, MR  MC, may not be on executives’ lips or in their manuals, but it does describe their behavior. It provides a framework for understanding
    business behavior. Thus, it is a very important part of understanding why the world
    looks and acts as it does.

    R E C A P

    1. The profit-maximizing rule is to produce the quantity at which marginal revenue equals marginal cost, MR  MC, and to sell that quantity at the price
    given by demand.

    SUMMARY
    ?

    1.

    What is the relationship between costs and output in the short run?

    The short run is a period of time just short enough so
    that the quantity of at least one of the resources cannot
    be altered.
    Average total costs are the costs per unit of output—
    total costs divided by the quantity of output sold.

    2.

    3. As quantity rises, total costs rise. Initially, as quantity
    rises, total costs rise slowly. Eventually, as quantity
    rises, total costs rise more and more rapidly.
    4. According to the law of diminishing marginal returns,
    when successive equal amounts of a variable resource
    are combined with a fixed amount of another resource, the additional output will initially rise but will
    eventually decline.
    5. The U shape of short-run, average-total-cost curves is
    due to the law of diminishing marginal returns.
    6. The objective of firms is to make a profit. The difference between sales, or the value of output, and the input costs (including the opportunity costs) is called
    economic profit.

    ?

    7.
    8.

    ?

    What is economic profit?

    Economists take into account all opportunity costs.
    Profit is total revenue less all costs.
    Normal accounting profit is a zero economic profit.
    Positive economic profit occurs when revenue is
    greater than all opportunity costs. Negative economic
    profit occurs when revenue is less than total opportunity costs.
    Why is profit maximized when MR  MC?

    9.

    Profit is maximized at the output level at which total
    revenue exceeds total costs by the greatest amount, at
    the point at which MR  MC.
    10. The supply rule for all firms is to supply the quantity at
    which the firm’s marginal revenue and marginal costs
    are equal and to charge a price given by the demand curve
    at that quantity.

    EXERCISES
    1.

    Use the table below and find average total costs and
    marginal costs.
    Output

    Costs

    0
    1
    2
    3
    4
    5

    $100
    175
    225
    255
    300
    400

    108

    ATC

    2.

    MC

    3.
    4.

    Use the completed table to do a and b.
    a. Plot each of the cost curves.
    b. At what quantity of output do marginal costs equal
    average total costs?
    Describe the relation between marginal and average
    total costs.
    In the following figure, if the firm has average total
    costs ATC1, which rectangle measures total profit?
    If the firm has average costs ATC2, what is total
    profit?

    Part Two / Consumers, Firms, and Social Issues

    7.

    Price per DVD (dollars)

    ATC 2
    MC

    E

    H

    ATC 1

    J

    K

    Boeing
    Sales
    Profits

    F

    C
    B
    G

    6.

    $423
    $26.9

    Liz
    Claiborne
    $622
    $56.2

    Circuit
    City
    $1,767
    $31.6

    8.
    D

    Quantity (number of DVDs)/time period

    Using the following demand schedule, compute marginal and average revenue:

    Price
    Quantity

    $5,601
    $254

    Goodyear

    I

    A

    MR

    5.

    What follows is some accounting information for each
    of the firms shown. Can you tell which firm is the
    most successful? Explain.

    $100
    1

    $95
    2

    $88 $80
    3
    4

    $70
    5

    $55
    6

    $40 $22
    7
    8

    Explain why a firm will be unable to earn positive
    economic profit in the long run if other firms can
    freely enter and compete with the existing firm. Explain why that firm will not earn negative economic
    profit in the long run.
    9. Can accounting profit be positive if economic profit
    negative? Can accounting profit be negative and economic profit positive? Explain.
    10. Use the following information to calculate accounting
    profit and economic profit:

    Sales
    Employee expenses
    Inventory expenses
    Value of owner’s labor in
    any other enterprise

    $100
    40
    20
    40

    Suppose the marginal costs of producing the good in
    exercise 5 is a constant $10 per unit of output. What
    quantity of output will the firm sell?

    Internet
    Exercise

    Use the Internet to experiment with marginal cost and marginal revenue and
    think about how managers make decisions every day.
    Go to the Boyes/Melvin, Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise link
    for Chapter 5. Now answer the questions that appear on the Boyes/Melvin website.

    Chapter 5 / Costs and Profit Maximization

    109

    Study Guide for Chapter 5
    ■ e. pay their employees more than other workers

    Key Term Match

    earn.

    Match each term with its correct definition by placing
    the appropriate letter next to the corresponding number.
    A.
    B.
    C.
    D.
    E.

    average total costs (ATC)
    marginal costs (MC)
    short run
    long run
    law of diminishing
    marginal returns
    F. economic profit

    G. zero economic profit
    H. positive economic
    profit
    I. negative economic
    profit
    J. normal profit
    K. fixed costs
    L. variable costs

    1. revenue larger than all costs
    2. costs that have to be paid even when production is
    zero
    3. per-unit cost; total cost divided by the total
    output
    4. revenue less all costs
    5. the additional cost of producing one more unit of
    output
    6. a period of time short enough so that the quantities
    of at least one of the resources cannot be varied
    7. profit that occurs when total revenue is greater
    than total opportunity costs
    8. profit that occurs when total revenue equals total
    opportunity costs
    9. costs that change relative to output
    10. declining marginal increases in output attributed to
    combining equal additional amounts of a variable
    resource with a fixed amount of another resource
    11. a period of time in which everything can be
    changed

    3

    A firm is getting normal profit when
    ■ a. revenue just pays all opportunity costs.
    ■ b. it has a zero economic profit.
    ■ c. revenue just pays the cost of all resources except
    capital.
    ■ d. all of the above are true.
    ■ e. only a and b are true.

    4

    A firm can increase its profit by producing another
    unit of output when
    ■ a. total revenue is more than total cost.
    ■ b. total revenue is less than total cost.
    ■ c. total revenue is equal to total cost.
    ■ d. marginal revenue is more than marginal cost.
    ■ e. marginal revenue is less than marginal cost.

    5

    The profit-maximizing rule for a firm is to set the
    price and sell the quantity at which
    ■ a. MC = ATC.
    ■ b. MR = MC.
    ■ c. AR = ATC.
    ■ d. TR = TC.
    ■ e. MR = ATC.

    Practice Questions and Problems
    1

    equation:
    2

    Quick-Check Quiz
    1

    2

    110

    According to the law of diminishing marginal returns,
    as successive units of a variable resource are added to
    some fixed resources, the additional output will
    ■ a. initially rise but will eventually decline.
    ■ b. initially decline but will eventually rise.
    ■ c. continually rise.
    ■ d. continually decline.
    ■ e. remain constant.
    The primary objective of business firms is to
    ■ a. sell as much as possible.
    ■ b. keep their total costs to the minimum.
    ■ c. keep their marginal costs to the minimum.
    ■ d. maximize profit.

    You calculate average total costs (ATC) by using this
    .

    You calculate marginal costs (MC) by using this equation:

    3

    .

    The short run is a period of time just short enough so
    that

    of the resources is
    .

    4

    Diminishing marginal returns happen in any type of
    business firm because the efficiency of variable resources depends on the
    the

    5

    of
    .

    Use the following total cost table for Joe’s Gourmet
    Hamburgers to calculate Joe’s ATC and MC. Then

    Part Two / Consumers, Firms, and Social Issues

    plot the TC curve on graph (a) below, and the ATC and
    MC curves on graph (b).
    Burgers
    0
    1
    2
    3
    4
    5
    6
    7
    8
    9
    10
    6

    TC
    $5.50
    9.00
    10.00
    10.50
    11.50
    13.00
    15.00
    17.50
    20.50
    24.00
    28.00

    ATC

    9

    MC

    $

    Last year, the accountant for Joe’s Gourmet Hamburgers gave Joe the following information:
    Revenues
    $200,000
    Labor costs
    140,000
    Land costs
    10,000
    Debt costs
    20,000
    Equity costs
    50,000

    $

    a. Joe’s profit was

    .

    b. Joe received a
    positive, zero) economic profit.

    (negative,

    c. Based on Joe’s results, other people are
    (likely, unlikely) to open
    new restaurants like Joe’s.

    The ATC and MC curves are shaped like the letter

    d. How much more revenue does Joe need to receive
    a normal profit (assuming his costs don’t

    .
    7

    Business firms try to maximize

    8

    a. If Joe’s Gourmet Hamburgers and other
    similar restaurants are currently receiving a

    change)?

    .

    (negative, positive, zero)
    economic profit, other people are likely to open
    similar restaurants.
    b. If Joe’s Gourmet Hamburgers and other similar restaurants are currently receiving a
    (negative, positive, zero)
    economic profit, other people are not likely to want
    to open similar restaurants.

    10 If the marginal revenue from selling another unit of

    output is
    (more, less) than
    the marginal cost, the firm should produce another
    unit.
    11 You have opened a coffee shop near the campus. You

    have a speical attribute in that your coffee tastes better
    than that offered by other shops. You have costs that
    come to $.80 per cup you sell and you sell the coffee
    at $1.50 per cup. If your special attribute can be readily copied, you will soon find that the price you sell

    (b) Unit Costs

    (a) Total Costs

    25

    Costs per Hamburger

    Costs per Hamburger

    30

    20
    15
    10
    5
    0

    1

    2

    3

    4

    5

    6

    7

    8

    Output (number of hamburgers)

    Chapter 5 / Costs and Profit Maximization

    9

    10

    10
    8
    6
    4
    2
    0

    1

    2

    3

    4

    5

    6

    7

    8

    9

    10

    Output (number of hamburgers)

    111

    the coffee at will
    . At that point
    you will be earning a
    profit. On the
    other hand, if your special attribute is a secret, much
    like Coca-Cola’s syrup formula, you will find that
    your price per cup will
    over time and
    your profit will be
    .

    12 When a firm earns more than enough revenue to pay

    all of the costs, including the opportunity costs of
    owners and/or investors, then we can expect others
    to
    . If it is relatively easy for others
    to enter a business and begin competing with the
    profitable firm, then we know that economic profit
    will be driven to
    by competition.
    If the profitable firm has or does something that creates the profit that others cannot easily mimic, then
    economic profit will be
    . Only when
    that special something can be mimicked or replaced
    will economic profit be driven to
    . If
    the government provides a license to operate the
    business, which only the profitable business has
    been able to get, then we expect the profitable firm
    to earn a positive economic profit for how long?

    taxes. Let’s assume that the EPA knows what the benefits
    and costs (in dollars) are from reducing pollution by various amounts. Using the benefits and costs in the following
    table, find the amount of pollution reduction that provides
    people with the biggest “profit.” Profit in this case is the
    net value people get from pollution reduction: the total
    benefits minus the total costs.
    Pollution Improvement:
    Tons Reduced per Day
    1
    2
    3
    4

    Marginal
    Benefits
    $ 10 million
    5 million
    2 million
    1 million

    1

    The plant should reduce pollution by
    tons per day.

    2

    Explain why you chose this amount.

    Marginal
    Costs
    $ 1 million
    4 million
    10 million
    30 million

    Exercises and Applications
    Profit Maximization and Pollution Reduction

    112

    ✸✔

    ACE s

    The
    ideas of profit maximization and of comparing marginal
    revenue and marginal cost to find the profit-maximizing
    output level can be useful even for organizations that are
    not involved in profit maximization. All organizations
    need to find the most effective ways of reaching their
    goals.
    Suppose you are the head of the Environmental Protection Agency (EPA), and you have to decide how much,
    if any, pollution a particular water treatment plant should
    be allowed to produce. Right now, the plant produces 4
    tons of pollutants per day. The plant is owned by the federal government, so any cleanup costs will be paid through

    -test
    elf

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    Part Two / Consumers, Firms, and Social Issues

    This page intentionally left blank

    Chapter 6

    ?

    Fundamental
    Questions

    1. What does free entry
    and competition
    mean?
    2. What is product
    differentiation?
    3. What are the
    benefits of
    competition?
    4. What is creative
    destruction?

    Competition

    I

    n the last chapter we started with a situation
    where a coffee shop is opened at a nice location
    near the school. The total costs—land, labor, and
    capital—add up to $.80 a cup. Initially the price is set at $1.50, so the coffee shop is
    experiencing a very nice profit of $.70. The profit is great, but it also looks great to
    others; as a result, someone else locates nearby and begins offering coffee for
    $1.40. Then still another begins selling it at $1.20. The process of people entering
    the business continues until the price is driven down to where it just covers all
    costs, $.80. This story illustrates the process of competition. A business starts,
    earns profits that exceed all costs, including even the costs of the owner’s time and
    investments, and this attracts competitors. But what occurs if rivals cannot enter the
    business or can enter but cannot duplicate perfectly what the first firm does? In this
    chapter, we examine answers to these questions. ■

    Preview

    1. COMPETITION AND ENTRY
    ?
    1. What does free entry
    and competition mean?

    The results of competition will be different depending on whether rivals can enter
    the business. If entry is free, then the profit will attract competitors. More competitors mean more supply, which results in a lower price. If entry is not free, then the
    results depend on how rivals try to compete.

    1.a. Commodities and Differentiation

    commodity: goods perceived
    to be identical no matter who
    supplies them
    perfect competition: a market
    structure characterized by such
    a large number of firms that no
    one firm has an effect on the
    market

    114

    When entry is free and rivals can duplicate identically what each other does, the
    price will be bid down until there is no more incentive for new businesses to
    enter. At this point, the product, the coffee, has been turned into what is called a
    commodity. If the coffee is a commodity, then one cup of coffee from one shop is
    no different than a cup from another shop, and there are lots of sellers of coffee.
    Economists refer to a situation where there are lots of sellers of a commodity product as perfect competition. With perfect competition, every product is identical
    and all sell for the same price—the opportunity cost.
    Now consider a slightly different scenario. The first coffee shop has created a
    special attribute that others find difficult to copy. The atmosphere or ambience of
    the shop and the special drinks—double, mocha, macchiato, with caramel and
    whipped cream on top—provide the original shop an attribute that customers value.
    In fact, they think that this attribute is worth $.10 on each cup of coffee. So what
    happens when the shop opens and sets a price of $1.50? It is earning a huge profit,

    Part Two / Consumers, Firms, and Social Issues

    The American Girls Phenomenon

    F

    or many years the parents of
    daughters complained about
    the dearth of toys available to
    them. Other than Barbie, what was
    there? Then came the American
    Girls, a collection of historical dolls
    made by Pleasant Company, each
    with a series of books describing
    each girl’s place in history. Girls love
    the dolls; nearly 4 million of them
    were sold in the past 11 years. In
    addition to the dolls, the Pleasant
    Company sold clothes, accessories,
    furniture, craft kits, and even matching clothes in real-girl sizes.
    The Pleasant Company dolls
    were so successful that competitors
    began to offer their own collections,
    each with a distinct twist. Like the
    American Girls, the dolls are sold
    exclusively by mail order, and each
    comes with its own predetermined,
    fantasy history. There’s Global
    Friends, which spins stories about
    girls from different cultures. Just
    Pretend offers Laurel the Woodfairy
    with her own trellis and lute and
    Alissa the Princess with an armoire
    and a throne. My Twinn dolls are
    custom-made to match

    photographs of their owners, down
    to the shape of their eyebrows and
    placement of freckles. Savannah
    and her friends from Storybook
    Heirlooms each have a distinct
    personality.
    Many of these dolls are sized just
    differently enough so that their
    expensive clothes won’t fit on dolls
    from rival collections. The 18-inch
    American Girls dolls, for example, are
    too chubby to fit into the clothes
    made for the more svelte 18-inch
    Magic Attic Club dolls. The Little
    Women dolls are 16 inches tall. My
    Twinn is 23 inches. Global Friends
    dolls are only 14 inches.
    The economic profit of these doll
    companies seems to have been
    driven to zero and, as a result,
    additional companies are not
    entering the market. American Girls
    and Mattel’s Barbie control more
    than 40 percent of the U.S. market.
    Barbie’s annual sales of almost $900
    million are more than three times
    larger than those of Pleasant
    Company’s American Girls, which in
    turn overshadow the sales of its
    competitors.

    Chapter 6 / Competition and Market Structures

    Economic Insight
    The doll story illustrates the
    market process. For years, there was
    only Barbie—a doll with dimensions
    that no real person could achieve
    and which focused on no
    intellectual aspects. Then an
    entrepreneur (Pleasant Company)
    comes up with a new product—
    American Girls dolls and the whole
    package of highly readable,
    fictionalized history books, clothes,
    and accessories—and is very
    successful. Other entrepreneurs see
    the success and want to get in on
    the good thing. They begin copycat
    companies, but to be successful,
    they have to be slightly different. In
    this case, the dolls are different
    sizes and have different stories than
    those of the American Girls. The
    success of Pleasant Company
    attracted new resources to the
    market—new companies. New
    companies with different
    approaches continued to enter the
    doll market until the potential for
    success looked no better than that
    for other industries, and the market
    topped out.

    115

    ?
    2. What is product
    differentiation?

    differentiated: a good service
    or firm that consumers
    believe to be somewhat
    unique
    monopolistic competition: a
    market structure characterized
    by a large number of firms,
    easy entry, and differentiated
    products

    $.70 per cup. Others enter and open up coffee shops. The price drops because there
    are more suppliers. The original coffee shop begins to lose business once the other
    shops are offering their coffee at a price below $1.40. As rivals continue entering,
    the price is driven down further, eventually resting at $.80 a cup. While rivals are
    selling the coffee at $.80, the original coffee shop is able to retain its sales by lowering price to $.90. The first is able to earn positive economic profit because of the
    value of its special attribute, if its cost of supplying its coffee are no different from
    the cost to the other shops. And, as long as that attribute is valued by consumers,
    the shop will be able to earn positive economic profit.
    A recent magazine surveyed coffee drinkers and found that more liked McDonald’s coffee than liked Starbucks coffee. Yet Starbucks charges $1.60 for a cup and
    McDonald’s, $1.20. Why? Because Starbucks sells not just the coffee, but the entire experience of going to a Starbucks shop. And until McDonald’s or some other
    coffee sellers come up with a way to take away the value that consumers place on
    the entire Starbucks experience, Starbucks will be able to earn those positive economic profits. Economists say that Starbucks has differentiated its product. Competitors offer a similar but not identical product. The difference is what consumers
    value, what they pay extra for. Economists refer to a situation where there are lots
    of sellers of slightly different products as monopolistic competition. With monopolistic competition, rivals will continue seeking ways to take sales from the first
    store even though they don’t try to do so by doing exactly the same thing the first
    store does. The prices may differ, but competition will drive economic profits to
    zero. For instance, Starbucks may have higher costs because it pays its employees
    more, and it has to do that to ensure that the Starbucks “experience” remains. So
    what happens is that the price of Starbucks is $.90 per cup while the price of another coffee supplier’s coffee is $.80 per cup, but both are earning zero economic
    profit. This too is the competitive process.

    1.b. Monopoly
    Consider yet still another scenario. Suppose the university has decided to allow
    only one coffee shop to locate on the campus. This coffee shop is the only seller of

    116

    Part Two / Consumers, Firms, and Social Issues

    monopoly: a market structure
    in which there is just one firm,
    and entry by other firms is not
    possible

    coffee in the vicinity of the campus. It has a monopoly. It can set a price of $1.50
    and not fear that competitors will enter and begin taking away sales because the
    university does not allow entry to occur. The coffee shop earns a profit of $.70 per
    cup. It has to pay the university in return for getting the monopoly, but as long as
    its profit is greater than zero, it is better off than if it did not have the monopoly.
    Moreover, since rivals cannot enter and compete with the monopoly, it can earn
    positive economic profit for as long as it is the sole supplier.
    Table 1 summarizes the different types of markets. Notice that with free entry,
    competition drives economic profits to zero. But, when entry is not free, such as
    in the monopoly case, profits are competed down to zero only if the monopoly
    disappears.

    1.c. Competition and the Shape of Demand Curves

    price taker: a firm in a
    perfectly competitive market
    structure

    Table 1
    Summary of Competition

    The initial coffee shop has a demand for its coffee that looks like the one illustrated
    in Figure 1(a). As the price of the coffee is lowered, the quantity sold increases.
    The firm determines it could maximize its profit-setting price at $1.50 per cup and
    selling 1,000 cups a day, as shown by the point where MR = MC. If there are no
    restrictions on entry, the profit made by the shop will attract competitors.
    As competitors open their shops, they provide more substitutes for consumers
    and take business away from the original shop. The demand curve shifts in and
    rotates so that it becomes flatter and flatter, as shown in Figure 1(b). If the coffee shop has created a unique or special attribute that consumers are willing to
    pay for, then the firm is able to earn positive economic profit. This is shown in
    Figure 1(b) by the price of $.90 per cup.
    As rivals continue to attack the profits of the first firm, the value of the attribute
    erodes. Either the cost of providing the attribute rises or the attribute itself loses
    value. If the value of the attribute disappears, then the coffee is a commodity, and
    every firm offers the exact same thing at the exact same price. This is illustrated by
    a demand curve that is perfectly flat (perfectly elastic), as shown in Figure 1(c).
    Figure 1(c) shows the demand for a single coffee shop once the coffee has become a commodity. The demand curve is horizontal, illustrating the idea that the
    individual shop has no ability to set a price above the total cost of $.80 per cup. If a
    firm does set a higher price, consumers go elsewhere, and no one buys anything at
    the higher-priced shop. For this reason, individual sellers in a commodity market
    are called price takers. They have to sell their good or service at the same price as
    everyone else in the market, the lowest possible price, which is equal to total costs.
    The only decision a commodity seller has to make is how much to sell. A commodity seller can sell as little or as much as it chooses, at the market price. It will
    sell nothing at a higher price, and it has no incentive to sell at a lower price. The
    coffee shop can sell one cup for $.80, two cups for $.80 apiece, three, four, and so
    on, cups for $.80 apiece. Each additional cup of coffee sold brings in $.80 of additional revenue. This means the demand and marginal-revenue curves are the same

    Type of
    Market

    Entry
    Condition

    Economic Profit
    After Entry

    Perfect competition
    (commodity)

    Easy (free)

    Zero

    Monopolistic
    competition

    Differentiation

    Positive until value of
    differentiation disappears

    Monopoly

    No entry

    Positive as long
    as monopoly exists

    Chapter 6 / Competition and Market Structures

    117

    Figure 1(a)
    The Coffee Shop
    The coffee shop creates a unique experience and determines the profit-maximizing price to be $1.50 per cup of
    coffee. This exceeds total costs of $.80 per cup, creating
    an economic profit of $.70 per cup.
    Figure 1(b)
    As rivals enter and compete with the initial coffee shop,
    the price is bid down. The shop lowers the price until it is

    receiving its opportunity costs, $.80 per cup, plus the value
    consumers place on its special attribute, $.10 per cup.
    Figure 1(c)
    As the value of the special attribute is eroded, the product
    becomes a commodity. The coffee and experience offered
    by the initial shop are not valued any differently than the
    coffee and experience offered by a different shop. The
    price is driven down to just equal opportunity costs. Economic profit is zero.

    Price
    Price

    Price

    MC

    ATC

    MC

    $1.50

    $.80

    D

    MC
    ATC

    $.90
    $.80

    MR
    MR

    Quantity (cups of coffee)

    D = MR

    $.80

    1,000

    ATC

    D2
    Quantity (cups of coffee)

    Quantity (cups of coffee)

    horizontal line. The quantity that the seller chooses to supply is the quantity that
    will maximize profit, and that is the quantity where MR = MC.
    Table 2 summarizes the different types of markets and the shapes of the demand
    curve for a single firm’s goods or services. Notice that with free entry (perfect competition), the demand curve is horizontal because there are absolutely no differences
    among firms. In addition, competition drives price down until it equals marginal
    cost. When there are some differences among firms, then the demand curve slopes
    down. Competition drives price down but as long as consumers value the differences among firms, price will be higher than marginal cost. When there is only one
    firm, then the demand curve slopes down and there is no competitor, so price is not
    driven down.

    R E C A P

    Table 2
    Summary of Demand Curves
    and Competition

    118

    1. When entry is easy or free and competitors can offer an identical product, no
    firm can earn positive economic profit.
    2. A commodity is a product that is identical no matter who sells it. A cup of
    coffee from one seller is no different in the consumer’s mind than a cup from
    a different seller. This type of market is called perfect competition.

    Type of
    Market

    Shape of
    Demand Curve

    Relationship of Price
    and MR = MC

    Perfect competition
    (commodity)

    Horizontal

    P = MR = MC

    Monopolistic
    competition

    Sloping down

    P > MR = MC

    Monopoly

    Sloping down

    P > MR = MC

    Part Two / Consumers, Firms, and Social Issues

    3. When a firm can create a special attribute that other firms cannot copy identically, the firm can earn positive economic profits as long as consumers place
    a value on that special attribute. Economists refer to a situation where products are slightly differentiated and there are lots of sellers as monopolistic
    competition.
    4. A monopoly is a sole supplier, that is, the only supplier of a good or service.
    If a firm has a monopoly, the firm can earn positive economic profit as long
    as the monopoly prohibits entry.
    5. The demand curve for a good or service will be downward sloping, illustrating the idea that as the price of the good or service is lowered, the quantity
    demanded will rise. The fewer substitutes there are, the more price inelastic
    demand is. As more and more competitors enter the business, consumers
    have more and more choices. As a result, demand for any single seller’s good
    or service will become more price elastic and the demand curve flatter and
    flatter.
    6. The demand curve for the seller of a commodity, that is, the demand for a
    good or service offered by a single seller in a perfectly competitive market,
    will be perfectly elastic or horizontal.

    2. CREATING BARRIERS TO ENTRY
    What have we learned to this point? One thing is that positive economic profit will
    not last long simply by doing the same thing others do. As more and more sellers
    do the same thing, the demand curve becomes flatter and flatter. Over time, the
    only way that positive economic profit will continue to be earned is if others cannot
    copy the unique activity or product that creates the profit. Barriers to entry, that is,
    restrictions on the ability of rivals to open coffee shops and begin competing
    against the incumbent firm, is the only way the incumbent can earn positive economic profit for a long period of time. By creating the special attribute that the
    other coffee shops could not create, the original shop was able to earn positive economic profit. Similarly, by obtaining the right from the authorities to have the only
    coffee shop near the university, the coffee shop is able to earn positive economic
    profit. The existence of economic profit will continue to attract rivals. They will
    seek ways to compete against the special attribute or to find ways to gain entrance
    even with the authorities attempting to block it. Once entry occurs, economic profit
    is driven to zero.
    If you owned the coffee shop, you would try to find ways to restrict or block entry by rivals. An important question to businesses is how they can create the special
    attribute that others cannot easily copy.

    2.a. Brand Names
    A well-known company can have a real advantage over newcomers. Aspirin might
    simply be aspirin, but Bayer Aspirin is much more expensive than generic aspirin.
    Why? Because of the brand name. To many people, the brand name is a signal of
    quality or reliability.
    Consider the case of a sidewalk vendor who sells neckties on the streets of
    a large city. If such a “firm” tells customers that it will guarantee the quality of
    its ties, customers will certainly question the validity of the guarantee since if
    the firm decides to go out of business, it can do so instantaneously. It has no headquarters, no brand name, no costly capital equipment, and no loyal customers to
    worry about. A firm with no obvious stake in the future has a difficult time persuading potential customers it will make good on its promises. In contrast, a firm
    that has devoted significant resources to items that have no liquidation value, such

    Chapter 6 / Competition and Market Structures

    119

    Ready, Set, Go. Two policemen
    aboard the new Segway scooter
    prepare to show how the scooter
    performs. The new product is
    unique and appears to have a
    large potential. The inventor is
    claiming that it could replace the
    automobile in those crowded,
    big-city areas, could serve as a
    city vehicle anywhere, and could
    even provide transportation for
    any short routes. Being a new
    product, it has no close substitutes. How long will this situation
    exist?

    sunk cost: cost that cannot be
    recouped

    120

    as advertising campaigns or physical structures like McDonald’s golden arches, is
    not as likely to pick up and leave at a moment’s notice.
    If the costs of entering a business are high, and if the costs are sunk, then firms
    are likely to be more reluctant to enter an industry. A sunk cost is an expenditure
    that cannot be recouped. What a firm spends on advertising can’t be recouped. The
    firm cannot sell the advertising to another firm. A firm that builds a sign or golden
    arches cannot then sell that sign or those arches to another firm. Sunk costs can
    serve as effective barriers to entry since they tell a potential new firm that it has to
    throw just as much money away on similar sunk expenditures if it is going to compete. If to compete with Microsoft, firms must also have interests in a film studio,
    then the costs to enter Microsoft’s business will have risen considerably. If to compete with Nike, a firm has to spend twice as much enlisting endorsements and on
    advertising, firms may be reluctant to enter the athletic shoe market.
    If all firms in a market have the same resources and capabilities, no strategy for
    earning economic profit is available to one firm that would not also be available to all
    other firms in the market. Any strategy that confers advantage could be immediately
    imitated by any other firm. However, if a firm has a unique resource, that resource
    may serve as a barrier to entry. A single family owned the only mine producing
    desiccant clay. For years, this clay was the only material that could meet certain
    necessary standards for inhibiting the accumulation of humidity in packaging.
    DeBeers controlled about 80 percent of the diamonds in the world when the
    Russian economy was tightly controlled by the government. DeBeers had a unique
    resource—acquisition and distribution of the diamonds. With the breakdown of the
    Soviet empire, DeBeers has had to fear a flood of diamonds and a reduction in
    the uniqueness of its resource.
    Microsoft has hired as many of the best scientists as it can. This stock of top scientists is expected to allow Microsoft to maintain its advantage in the software
    market. These scientists are a unique resource.

    Part Two / Consumers, Firms, and Social Issues

    Most monopolies are government created. The U.S. Postal
    Service has a monopoly on firstclass mail—no one else is
    allowed to sell exactly the same
    service. Of course, with the emergence of private postal services
    such as FedEx, and with Internet
    and fax services, that monopoly
    is declining in value.

    2.b. Firm Size and Economies of Scale

    economies of scale: the
    decreases in per-unit costs
    when all resources are
    increased

    diseconomies of scale: the
    increases in per-unit costs when
    all resources are increased

    An important barrier to entry can be the size of the firm relative to the market. If a
    firm must be large in order to enter an industry, then the costs of being large may be
    too much, and entry may be very difficult, if not impossible. In this case, a firm already in the industry may be able to earn positive economic profit. Size can be an
    advantage when it produces economies of scale.
    Remember the distinction between the short run and the long run? The short
    run is a period of time just short enough so that at least one of the resources
    cannot be changed. The relationship between output and costs in the short run is
    explained by the law of diminishing marginal returns. In the long run, everything is variable. This means that the law of diminishing marginal returns does
    not apply. The relationship between output and costs in the long run is defined
    by whether there are economies or diseconomies of scale. The term economies
    of scale means that as the size of a firm increases (all of its resources are increased), its per-unit costs decline. If economies of scale exist, a larger firm can
    produce a product at a lower per-unit cost than a smaller firm can. This means
    that a new entrant would have to enter as a big firm in order to compete with existing firms.
    Economies of scale can arise because a larger size allows more specialization; an
    employee can focus on one activity rather than trying to do everything. Economies of
    scale also can result because larger machines are more efficient than smaller ones;
    large blast furnaces produced many more tons of steel than the smaller, open-hearth
    furnaces in the same time and for about the same cost.
    However, larger size does not automatically improve efficiency. The specialization that comes with large size often requires the addition of specialized managers.
    A 10 percent increase in the number of employees may require an increase greater
    than 10 percent in the number of managers. A manager to supervise the other managers is needed. Paperwork increases. Meetings are held more often. The amount
    of time and labor that are not devoted to producing output grows. It may become
    increasingly difficult for the CEO to coordinate the activities of each division head
    and for the division heads to communicate with one another. Larger machines are
    not always more efficient than smaller ones. A larger building may not allow a
    more efficient production than a smaller building. When increasing size leads to
    higher per-unit costs, we say that there are diseconomies of scale.

    Chapter 6 / Competition and Market Structures

    121

    Now You Try It
    Sketch the long-run average
    total cost curve when a firm
    experiences economies of scale
    from zero output to an output
    quantity of 1 million per day
    and then diseconomies of scale
    for output quantities greater
    than 1 million.

    R E C A P

    2.b.1. Large Firm Advantage, Disadvantage It might seem that a large firm
    would always have an advantage over smaller firms if there are economies of scale.
    In fact, it would seem that the market would have to be just one firm—a monopoly—since the largest firm would be able to drive the others out of business, but
    appearances can be deceiving.
    Most industries experience both economies and diseconomies of scale. Consider
    the fresh-cookie industry. Mrs. Fields Cookies trains the managers of all Mrs.
    Fields outlets at its headquarters in Park City, Utah. The training is referred to as
    going to Cookie College. By spreading the cost of Cookie College over more than
    700 outlets, Mrs. Fields Cookies is able to achieve economies of scale. However,
    the company faces some diseconomies because the cookie dough is produced at
    one location and distributed to the outlets in premixed packages. The dough factory
    can be large, but the distribution of dough produces diseconomies of scale that
    worsen as outlets are opened farther and farther away from the factory.
    When long-run costs are characterized by economies of scale for smaller sizes
    and then by diseconomies of scale for larger sizes, the larger firm may or may not
    have a cost advantage over the smaller firm. It depends on demand. If demand is
    very large, then the firm will produce only an amount that allows it to experience
    economies of scale. Once diseconomies of scale begin, that is, once per-unit costs
    begin to rise, the firm will not produce any more. In this case, the very large firm
    would not have an advantage over the small firm. When demand is sufficient only
    for a firm to experience economies of scale, then the larger firm has an advantage
    over the smaller firm. When demand is so large that a firm would experience diseconomies of scale trying to supply all of demand, then the large firm does not
    have an advantage over a small firm. When only diseconomies of scale occur, small
    firms have an advantage over larger firms.
    Diseconomies of scale typically arise because of the growth of bureaucracy. It takes
    more supervisors to manage an increasing number of employees. It requires more
    meetings for the increased number of supervisors to communicate. All these increased
    nonproductive activities lead to rising per-unit costs as the size of the firm increases.

    1. Economic profit induces entry and new competition, which drives economic
    profit to zero unless there are barriers.
    2. Barriers to entry include brand name and reputation, and unique resources
    and size can serve as a barrier to entry in certain circumstances.
    3. The long run is a period just long enough so that all resources are variable;
    there are no fixed resources.
    4. Economies of scale occur when the per-unit costs decline as all resources
    (the size of the firm) increase in the long run.
    5. If an industry is characterized by economies of scale, then the large firm can
    produce at lower per-unit costs than the small firm can. To enter this industry,
    a firm must be large.
    6. Whether economies of scale give a cost advantage to a large firm depends on
    the extent of the market. If demand is sufficiently large so that a large firm
    can realize economies of scale, then firm size is a distinct advantage.
    7. Diseconomies of scale occur when as the size of the firm increases, the perunit costs rise.

    3. THE BENEFITS OF COMPETITION
    Competition occurs in many ways. Wal-Mart is able to offer lower prices because
    of its economies of scale. Nordstrom does not attempt to offer lowest prices.

    122

    Part Two / Consumers, Firms, and Social Issues

    ?
    3. What are the benefits
    of competition?

    Instead, it focuses on service. Sharper Image attempts to be the first to offer a
    product—charging a higher price than other stores will when the product is more
    widely available. Apple focuses on innovation, attempting to offer products or features that others don’t have. Each of these forms of competition is intended to do
    the same thing: earn a positive economic profit. But no matter on which basis competition occurs, if others can do the same thing, economic profit will be driven to
    zero. If another department store could match Nordstrom’s products and service
    but do so at a lower price, consumers would abandon Nordstrom and shop at the
    other store. This would drive profits down until they were at the normal or zero
    economic profit level. If iPods can be replaced with another company’s MP3, then
    Apple’s profit will be driven to the normal level.
    Competition benefits individuals. Consumers are able to get the goods and services they desire and are willing to pay for at the lowest possible prices (at zero
    economic profit). In addition, resources are used in their highest-valued activities.
    If resources used to produce transistor radios are no longer valuable in that activity,
    they will be reallocated to other uses, say building iPods.

    3.a. Consumer Surplus

    consumer surplus: the
    difference between what
    consumers are willing to pay
    and what they have to pay to
    purchase some item

    Economists like to illustrate the benefits of competition by comparing the results of
    a commodity market with the results of a monopoly. As we have seen, when entry
    can occur, no firm can get away with anything. Any time consumers don’t like a
    product or a service, they can switch to another firm. Any time a firm earns positive
    economic profit, other firms will copy that firm and eventually drive the price down
    to its lowest possible level.
    A simple way to illustrate the benefits of competition is to look at a demand and
    supply diagram. The demand for coffee is the sum of all the consumer demands for
    coffee at all the coffee shops in existence. A demand curve measures the price that
    buyers are willing and able to pay for each quantity of a good or service. When the
    market is a commodity market and free entry has driven prices to where they just
    cover opportunity costs, then consumers have to pay only the equilibrium price and
    sellers can sell only at the equilibrium price. Notice in Figure 2 that although a
    consumer would be willing and able to pay Pm for a cup of coffee, she only pays
    the market price, Pfe. The triangle ABPfe measures how much savings consumers
    get by paying the equilibrium price rather than what they would be willing and able
    to pay. This is called consumer surplus.

    Figure 2
    The demand curve shows the quantities that consumers are willing and
    able to pay for the good or service. The
    market price, Pfe, is determined by
    rivals competing with each other and
    the price being bid down until it just
    matches opportunity costs per unit of
    output. Although some consumers
    would be willing and able to purchase
    some quantities at prices higher than
    the market price, they don’t have to.
    They only have to pay the market
    price. Consumers thus get a bonus
    from competition, the area indicated
    by the triangle ABPfe. This is consumer
    surplus.

    Chapter 6 / Competition and Market Structures

    Price

    A

    Consumer Surplus

    Pm

    Pfe

    B
    D

    Quantity (cups of coffee)

    123

    deadweight loss: the loss
    of consumer and producer
    surplus when entry is restricted

    What happens to consumer surplus when there is no competition? Without competition, the coffee seller is a monopoly, and a monopoly firm can charge a higher
    price by selling a lower quantity of output. Notice in Figure 3, which is just Figure
    2 reproduced, that the higher price Pm means less is sold, Qm. This means that
    consumer surplus is reduced from ABPfe to ACPm. The consumer surplus indicated
    by the rectangle Pfe ECPm is taken from the consumer and collected by the monopoly. And, the consumer surplus that was indicated by the triangle CEB is simply
    lost, collected by neither the consumers nor the firm. This loss carries the name
    deadweight loss.
    Deadweight loss is a measure of the benefits society gains from competition that
    disappear when competition is limited or restricted. The greater the barriers to entry, the more economic profit the firm can earn, the longer the firm can continue to
    earn positive economic profit, and the fewer the benefits that the consumer gains. It
    is entry and competition that generate the benefits of the market system. It is restrictions to entry that transfer consumer surplus to producers and create deadweight losses.

    3.b. Creative Destruction

    ?
    4. What is creative
    destruction?

    Competition benefits society by providing the goods and services consumers are
    willing and able to buy, by providing these at the lowest possible cost, and in this
    process by ensuring that resources are allocated to their highest-valued use. What
    does it mean to say resources are allocated to their highest-valued use? Do you
    know what a vacuum tube is—or was? It was the amplifying device that allowed
    televisions and radios to work. But it was large and cumbersome. The use of transistors instead of vacuum tubes meant that televisions and radios could be much
    smaller and require far less power to operate. The typical portable radio of the
    1950s was about the size and weight of a lunchbox, and contained several heavy
    (and nonrechargeable) batteries. By comparison, the “transistor” could fit in a
    pocket and weighed half a pound or less and was powered by standard flashlight
    batteries or a single compact 9-volt battery. The resources that had been used in
    vacuum tube manufacture, distribution, use, and sale were left without uses. They
    were either discarded or recycled to be used in another activity.

    Figure 3

    Price

    Monopoly and Consumer Surplus
    Without competition, the firm can charge a higher price by
    reducing the quantity it sells, price Pm and quantity Qm.
    The consumer surplus is reduced to the triangle APmC. The
    rectangle PmCE Pfe, which was consumer surplus, is now
    taken by the monopolist. The triangle CEB, which was
    consumer surplus, is just wasted, going to neither
    consumer nor seller.

    A

    Pm

    Pfe

    Consumer
    Surplus

    Consumer Surplus
    Transferred to
    Monopolist

    C

    Deadweight Loss

    B
    E

    D

    Qm
    Quantity (cups of coffee)

    124

    Part Two / Consumers, Firms, and Social Issues

    creative destruction: the
    process of competition
    whereby old, inefficient, or
    obsolete goods, services, and
    resources are driven out of
    business as new or efficient
    technologies and goods and
    services arise.

    R E C A P

    The transistor radio remains in existence, but is declining in use. It is being replaced by MP3 devices such as the iPod. People want to listen to the music they desire rather than listening to the talk or music offered by a radio station. Resources
    that were used in manufacturing vacuum tubes were left without tasks once consumers switched to the transistors. Resources used in transistor radios are being left
    without tasks as people switch to the MP3s. This means that some land previously
    used for buildings, equipment, and retail stores that sold transistor radios will be
    left without uses. Some employees will be left without jobs. Over time, some of
    these resources and employees will find uses in other activities, where they have
    more value than they would in the transistor business. This process of the destruction of old, inefficient activities is called creative destruction. Competition is the
    engine of creative destruction.
    In 1900, 47 percent of the U.S. labor force was employed in agriculture. Today,
    only 3 percent are employed in agriculture. Yet, more agriculture is produced today
    than in 1900, and 44 percent of the labor force is not unemployed. What occurred?
    Where did all these people go? Competition drove resource owners to seek activities where the resources had higher value. People left the farm to find employment
    in the city.
    Creative destruction typically takes time and can be a difficult, even cruel
    process. It takes time for the competition to make some occupations and some
    goods and services obsolete. And it takes time for resource owners to find new
    ways to increase the value of their resources. People without a job on the farm
    typically cannot find jobs in manufacturing the next day. Training and education
    typically are necessary for people to be ready for a new occupation. A man working
    in a steel mill for 30 years doing the same thing day after day is suddenly out of a
    job when the steel mill closes due to competition from steel around the world. This
    is sad for the man and his family. It is difficult for them and for those who sell
    the family food, clothing, and other goods and services. Over time, however, the
    replacement of the steel mill makes society better off. Steel becomes less expensive, which means cars, trucks, trains, planes, and buildings are less expensive.
    Since consumers spend less on these things and on the goods and services that
    use these things, they have more income to spend on other things. iPods are invented and people have the money to buy them. Resources have been reallocated
    from the steel mills to the manufacture of cars, trucks, trains, planes, and iPods.
    Society’s incomes and standards of living have risen. But, families that have to go
    through the experience of losing jobs and incomes as creative destruction works its
    way may never recover. This aspect of competition has led many nations to restrict
    competition.

    1. Consumer surplus is a measure of the benefits consumers get from competition and free entry. It is the difference between the market price and the price
    consumers would be willing and able to pay for a good or service.
    2. Without competition, consumer surplus is reduced because the seller is able
    to charge a higher price and offer a smaller quantity of a good or service for
    sale.
    3. Deadweight loss is a measure of the benefits that would result from competition and free entry when entry is limited or restricted.
    4. Creative destruction is a term given to the process of competition whereby
    old, inefficient, or obsolete goods, services, and resources are driven out of
    business as new or more efficient technologies and goods and services arise.

    Chapter 6 / Competition and Market Structures

    125

    SUMMARY
    ?

    1.
    2.

    3.

    ?

    4.

    5.
    6.

    7.

    8.

    What does free entry and competition mean?

    With free entry and competition, firms will earn zero
    economic profit.
    Positive economic profit attracts rivals who bid the
    price down until firms are able to pay for opportunity
    costs but nothing more. This type of market is referred
    to as a commodity market and called perfect competition.
    When a firm offers something unique or different, the
    demand curve for its good or service is downward
    sloping. If the firm earns a positive economic profit
    and rivals can open businesses that offer the same
    thing, then the demand curve for the first firm shifts in
    and flattens out or becomes more elastic. If competition results in the firms offering identical goods and
    services, then the demand curve for any one firm is
    horizontal, perfectly elastic.

    ?

    9.

    What are the benefits of competition?

    Competition drives price to the lowest possible level,
    where opportunity costs are paid and economic profit
    is zero.

    10. Competition ensures resources are used where their
    value is highest.
    11. Competition drives inefficient and obsolete activities
    out of existence.
    12. The benefits of competition can be illustrated as
    consumer surplus, the difference between what consumers would be willing and able to pay and the market price or price they actually pay.
    13. Barriers to entry enable firms to earn positive economic profit. Prices are not at their lowest possible
    level.
    14. Differentiation can serve as a barrier to entry.

    What is product differentiation?

    15. Size can serve as a barrier to entry.

    If a firm is able to create a special attribute, some way
    to differentiate its product that consumers value, then
    entry and competition will not necessarily drive economic profit to zero. If consumers place a value on the
    attribute that other firms can not compete with, then the
    firm is able to earn positive economic profit as long as
    consumers continue to value that special attribute.
    If a firm is the only firm with that attribute, it is called
    a monopoly.
    A market in which firms offer similar but not identical
    products and can begin a business easily are called
    monopolistic competition.
    If entry is easy, it is not possible for a firm to earn positive economic profit in the long run. If a firm earns a
    positive profit, others see that the firm is earning more
    than the owners’ opportunity costs and want to get in
    on the good thing as well. More firms enter the business, compete with the first, and drive profit to zero.
    If entry is difficult, a firm can earn a positive economic profit for as long as entry does not occur.

    16. Economies of scale occur when the costs per unit of
    output decline as all resources (the size of the firm)
    increase, that is, as output rises.
    17. In an industry or business that has economies of scale,
    the larger firms can produce more cheaply than the
    smaller firms. As a result, the larger firms can sell at a
    price that is lower than what the smaller firms can.
    ?

    What is creative destruction?

    18. Competition means that firms have to offer what consumers want at prices they are willing and able to pay.
    Firms that are wasteful or inefficient and firms that offer obsolete products will be driven out of business. In
    other words, businesses and industries are destroyed
    by competition as new ones are created.
    19. Creative destruction is part of the process of creating
    benefits for society. It also means that some members
    of society will be harmed by competition. Resources
    used in the activities that are obsolete or inefficient
    will be displaced.

    EXERCISES
    1.

    2.

    126

    Using a single industry, contrast and compare perfect
    competition and monopoly. For instance, using the
    coffee shop, explain how its behavior might differ if it
    had many rivals who would and could copy whatever
    it does or it had no rivals.
    Which would you think best characterizes the following businesses—a commodity market, a market with
    differentiation, or a monopoly?

    3.

    a. airlines
    b. fast food
    c. computer chips
    d. corn
    e. diamonds
    A monopolist has no rivals. Yet, it cannot simply set
    an exorbitantly high price. Do you agree with this
    statement? Explain.

    Part Two / Consumers, Firms, and Social Issues

    Output

    Price

    Total Costs

    1

    $5

    $10

    2

    5

    12

    3

    5

    15

    4

    5

    19

    5

    5

    24

    6

    5

    30

    7

    5

    45

    Total Revenue
    (P  Q)

    8. Draw a perfectly elastic demand curve on top of a
    standard U-shaped, average-total-cost curve. Now add
    in the marginal-cost and marginal-revenue curves.
    Find the profit-maximizing point, MR  MC. Indicate
    the firm’s total revenue and total costs.
    9. Describe profit maximization in terms of marginal
    revenue and marginal costs.

    4.
    5.

    Explain why firms advertise.
    Give ten examples of differentiated goods or services.
    Explain what differentiates them.
    6. Why will a firm choose to produce where MR = MC?
    Why not choose a quantity where MR > MC?
    7. Use the information in the table to calculate total
    revenue, marginal revenue, and marginal costs. Indi-

    Internet
    Exercise

    cate the profit-maximizing level of output. What
    market structure is this firm operating in? What
    would change if the structure were monopolistic
    competition?

    10. Using demand curves, illustrate the effect of product
    differentiation on haircutters.
    11. Why might society prefer a situation in which entry
    can occur to a situation in which entry is restricted?
    12. Under what circumstances would a large size provide
    an advantage to a firm? How could it serve as a barrier
    to entry?

    Use the Internet to examine why Americans are paying more for health care but not
    living longer, and to find out why the De Beers cartel operates and has lasted so long.
    Go to the Boyes/Melvin, Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise link
    for Chapter 6. Now answer the questions that appear on the Boyes/Melvin website.

    Chapter 6 / Competition and Market Structures

    127

    Study Guide for Chapter 6
    Key Term Match

    2

    Regardless of market structure, a firm maximizes its
    profits by producing the quantity of output at which
    ■ a. P = MR.
    ■ b. P = MC.
    ■ c. MR = MC.
    ■ d. MC = D.
    ■ e. D = MR.

    3

    When the owner of a firm is getting zero economic
    profit,
    ■ a. the owner should exit that market in the short
    run.
    ■ b. the owner should exit that market in the long
    run.
    ■ c. the owner cannot make any more money by
    exiting the market and doing something else
    with her resources.
    ■ d. the owner is not receiving any income from
    owning the firm.
    ■ e. the owner is getting rich.

    4

    In which market structures do firms receive just a normal profit in the long run?
    ■ a. monopoly and perfect competition
    ■ b. monopolistic competition and perfect
    competition
    ■ c. monopoly and monopolistic competition
    ■ d. monopoly and oligopoly
    ■ e. monopolistic competition and oligopoly

    5

    What is the most important determinant of whether or
    not firms receive economic profits in the long run?
    ■ a. how easy it is for new firms to enter the market
    ■ b. the size of the firms in a market
    ■ c. the size of the market overall
    ■ d. the amount of taxes firm owners pay
    ■ e. the amount of taxes the firms’ customers pay

    6

    The benefits that come from an exchange in a market
    are
    ■ a. deadweight loss minus consumer surplus.
    ■ b. producer surplus plus consumer surplus.
    ■ c. consumer surplus minus deadweight loss.
    ■ d. only deadweight loss.
    ■ e. consumer surplus plus deadweight loss.

    7

    Creative destruction is less likely to occur when
    ■ a. entry is free than when entry is restricted.
    ■ b. entry is not allowed.
    ■ c. entry can occur easily.

    Match each term with its correct definition by placing
    the appropriate letter next to the corresponding number.
    A.
    B.
    C.
    D.

    commodity
    perfect competition
    differentiated
    monopolistic
    competition
    E. monopoly
    F. price takers

    G. sunk cost
    H. economies of scale
    I. diseconomies of
    scale
    J. consumer surplus
    K. deadweight loss
    L. creative destruction

    1. a market structure characterized by a large number
    of firms, easy entry, and differentiated products
    2. a good, service, or firm that consumers believe because to be somewhat unique
    3. a market structure characterized by such a large
    number of firms that no one firm has an effect on
    the market
    4. the loss of surplus when entry is restricted
    5. old, inefficient activities driven out of business by
    competition
    6. cost that cannot be recouped
    7. a market structure in which there is just one firm,
    and entry by other firms is not possible
    8. the decreases in per-unit costs when all resources
    are increased
    9. the difference between what consumers are willing to pay and what they have to pay to purchase
    some item
    10. the increases in per-unit costs when all resources
    are increased
    11. firms selling in commodity market
    12. goods perceived to be identical matter who
    supplies them

    Quick-Check Quiz
    1

    128

    Which of the following market characteristics are not
    used to define market structures?
    ■ a. the number of firms in the market
    ■ b. the ease of entry into the market by new
    competitors
    ■ c. the percentage of the firm’s income that is paid
    in taxes
    ■ d. the type of product produced (identical or
    differentiated)
    ■ e. All of the above characteristics are used to
    define market structures.

    Part Two / Consumers, Firms, and Social Issues

    ■ d. government does not protect industries.
    ■ e. producers are price takers.
    8

    9

    the market, driving the market price
    (up, down) and economic profits
    (up,
    down). This will continue until firms are receiving

    Entry by new firms drives
    ■ a. profits to their maximum.
    ■ b. normal profits to zero.
    ■ c. profits to their minimum.
    ■ d. economic profits to their maximum.
    ■ e. economic profits to zero.

    profits.
    6

    run, firms will

    If there are economies of scale, then
    ■ a. a larger firm can produce a product at a lower
    cost than a small firm can.
    ■ b. a larger firm can produce a product at a higher
    cost than a small firm can.
    ■ c. a larger firm can produce a product at the same
    cost as a small firm can.
    ■ d. small firms make more profits than large firms.
    ■ e. small firms make the same profits as large
    firms.

    Practice Questions and Problems
    1

    The existing firms in a perfectly competitive market
    are currently receiving economic losses. In the long

    the market, driving the market price
    (up, down) and economic profits
    (up,
    down). This will continue until firms are receiving
    profits.
    7

    (many,

    few, one) firms are producing a(n)
    (identical, differentiated) product, and entry is

    In

    monopolistic

    competition,

    firms

    that

    earn

    (economic profits, economic
    losses, normal profits) in the long run will not remain
    in business.
    8

    If entry into a market is restricted, consumer surplus
    will become
    than if entry is not restricted.

    competition is the market
    structure in which

    (enter, exit)

    9

    (larger, smaller)

    The following graph shows a market with free entry,
    with price and quantity determined by the point where
    demand and supply cross. Mark the area of consumer
    surplus with horizontal lines.

    (easy, difficult, impossible).
    2

    competition is the market
    (many,

    few, one) firms are producing a(n)
    (identical, differentiated) product, and entry is

    S

    Price

    structure in which

    (easy, difficult, impossible).
    3

    Which type of market is also called a commodity
    market?

    4

    D

    10 A firm will have a

    In the short run, new firms
    (do, do not) have time to enter a market. In the long
    run, new firms
    have time to enter a market.

    Quantity

    (do, do not)

    (lower,
    higher) price elasticity of demand if customers believe
    its product is better than its competitors’ products than
    it would if customers believe its product is the same as
    its competitors’ products.

    11 List two ways that a firm can create barriers to entry.
    5

    The existing firms in a perfectly competitive market
    are currently receiving economic profits. In the long
    run, firms will

    (enter, exit)

    Chapter 6 / Competition and Market Structures

    129

    12 Aluminum is extracted from a mineral called bauxite.

    Before World War II, the Aluminum Company of
    America owned many bauxite deposits and tried to
    buy new deposits as they were discovered. Use the
    concepts discussed in this chapter to explain why
    Alcoa bought all that bauxite.

    13 Economies of scale exist when average costs

    Joe’s Gourmet Hamburgers: Current Demand and Costs

    Quantity
    Sold/Hour
    1
    2
    3
    4
    5
    6
    7
    8

    MC
    $12.50
    6.00
    2.00
    2.50
    3.00
    3.50
    4.00
    4.50

    P
    $12.00
    11.00
    10.00
    9.00
    8.00
    7.00
    6.00
    5.00

    MR
    $12.00
    10.00
    8.00
    6.00
    4.00
    2.00
    0
    −2.00

    ■ a. Joe’s current profit-maximizing quantity is

    (increase, decrease, remain
    the same) as the size of the firm increases.

    hamburgers.

    ■ b. His current profit-maximizing price is

    14 Diseconomies of scale exist when average costs

    .

    ■ c. At this quantity and price, Joe’s economic profit

    (increase, decrease, remain
    the same) as the size of the firm increases.
    15 Explain why economies of scale can be a barrier to

    ATC
    $26.50
    16.25
    11.50
    9.25
    8.00
    7.25
    6.79
    6.50

    would be
    2

    entry.

    .

    The following table shows the agency’s estimates of
    Joe’s demand and costs after the advertising campaign.
    Joe’s Gourmet Hamburgers:
    With Advertising Campaign

    Exercises and Applications
    Is Advertising Profitable? Joe’s Gourmet Hamburgers
    is thinking about using advertising to differentiate its burgers from all the other burgers in town. An advertising
    agency has developed a campaign that will add $5 per hour
    to Joe’s costs. The agency also estimated the increases in demand it expects Joe’s Gourmet Hamburgers to get from the
    campaign.
    1

    Quantity
    Sold/Hour
    1
    2
    3
    4
    5
    6
    7
    8

    ATC
    $31.50
    18.75
    13.17
    10.50
    9.00
    8.08
    7.50
    7.13

    P
    $15.00
    13.75
    12.50
    11.25
    10.00
    8.75
    7.50
    6.25

    MR
    $15.00
    12.50
    10.00
    7.50
    5.00
    2.50
    0
    −2.50

    ■ a. Joe’s profit-maximizing quantity here is
    hamburgers.

    ■ b. His profit-maximizing price is
    .
    ■ c. At this quantity and price, Joe’s economic profit
    would be

    The following table shows Joe’s Gourmet Hamburgers’
    current demand and costs.

    ACE s



    130

    MC
    $12.50
    6.00
    2.00
    2.50
    3.00
    3.50
    4.00
    4.50

    -test
    elf



    .

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    Part Two / Consumers, Firms, and Social Issues

    This page intentionally left blank

    Chapter 7

    ?

    Fundamental
    Questions

    1. Why don’t people
    like market
    allocation?
    2. How do businesses
    attempt to interfere
    with market
    allocation?
    3. What are market
    failures?
    4. How might market
    failures be corrected?
    5. What are
    government failures?

    Business, Society,
    and the Government

    C

    hapter 2 began with a discussion of allocation
    mechanisms and efficiency. The conclusion
    of the discussion was that the market system
    was generally the most efficient—it best satisfied people’s wants and needs and
    raised their standards of living. Without anyone dictating what buyers and sellers do,
    the market determines a price for each traded good at which the quantities that people are willing and able to sell are equal to the quantities that people are willing and
    able to buy. Day in and day out, the market system induces people to employ their
    talents and resources where they have the highest value. People do not have to be
    fooled, cajoled, or forced to do their parts in the market system. Instead, they pursue
    their own self-interests and, in so doing, generate the most good for society.
    In Chapter 6 we learned more about how that system works. Firms acquire resources and then organize and coordinate the resources to create and offer for sale
    various goods and services. The value that consumers place on these goods and
    services must be more than the value they place on the individual resources alone
    or else the firm will cease to exist. When a firm’s goods and services have more
    value than the opportunity cost of the resources used to create and sell the goods
    and services, then rivals will begin to compete with that firm. In other words, when
    economic profit is negative, the firm will cease to exist; when economic profit is
    positive, the sharks will attack. Rivals will enter and compete. People will get the
    goods and services they want at the lowest possible prices and resources will be
    used where their value is highest. ■

    Preview

    1. ALTERNATIVES TO THE MARKET
    Governments build highways and provide medical insurance, welfare, border security, schools, and education. Government tells power companies what prices they
    can charge for electricity and cable suppliers what prices they may charge for cable
    service; specifies which radio station broadcasts on which frequency; which airline
    can fly to which city; and so on. Many goods and services are allocated by firstcome first-served—medical care, classes at schools, access to highways, airline
    flights, and tickets to concerts or athletic events. If the market system is such an efficient and beneficial mechanism, why is it not universally relied on? The answer is
    either that people don’t like the results of competition or that the market does not
    work very well in certain situations.

    132

    Part Two / Consumers, Firms, and Social Issues

    70

    Agreement with Allocation
    Mechanisms

    60

    The vertical axis shows the
    percentage of people who
    agreed with the use of the
    allocation mechanism in each
    circumstance. The horizontal
    axis lists the four allocation
    mechanisms considered.
    (Percentages need not equal
    100, since someone could
    choose the same answer for
    more than one question.)

    Percent Agreeing

    Figure 1

    50
    40
    30
    20
    10
    0

    Price
    Non-Health

    ?
    1. Why don’t people like
    market allocation?

    First
    Come

    Gov't

    Random

    Health

    1.a. Disagreement with the Market Outcome
    The result of competition is not always happy and cheery. Some people are
    displaced from jobs and others experience a loss of income as their resources
    become replaced. Those who are willing and able to pay for something get that
    something while those not willing or not able do without. These facts may cause
    people to oppose or dislike market allocation. The questionnaire in the preview to
    Chapter 2 gives an indication of the attitudes people have toward market outcomes.
    In Figure 1, the allocation mechanisms price, first-come first-served, government,
    and random are listed across the horizontal axis for two types of goods and services, non-health related and health related. The vertical axis shows the percentage
    of people responding to the questionnaire in various locations throughout the
    United States who stated that they agreed with the use of the allocation mechanism
    in each circumstance. The percentage of people who agree with the market (price)
    for non-health items is about 50 percent, whereas it is only about 20 percent for the
    health-related goods and services. The percentage that agree with the government
    is about 40 percent for non-health items and near 70 percent for health-related
    items. The percentages agreeing with first-come first-served or with random are
    between the market and the government.
    It is clear that many people do not like the outcome of markets, especially concerning life and death issues. When people do not like an outcome, they may call
    on the government to change the outcome. Politicians will do what voters elect to
    have done. So one reason that the government intervenes in markets or replaces the
    market entirely and serves as the allocation mechanism is the attitude of the general
    public about market allocation.

    1.b. Cartels, Collusion, and Monopolization
    Another reason that government intervenes in the market process is to enhance
    competition or, as some people say, to create a level playing field. The objective of
    a business is to earn the largest economic profit possible. The goal of a business is

    Chapter 7 / Business, Society, and the Government

    133

    Global Business Insight

    Dumping

    D

    umping means that a firm
    sells its products for less than
    its cost of production or, in
    other words, sells at a loss. Why
    would a firm sell at a loss? One reason could be that a firm would sell
    in one market at a loss so that it
    could run other firms out of that
    market and then control the market.
    Of course, this strategy would be a
    success only if once the firm had
    control of the market, it could keep
    others from entering that market.
    Thus, dumping is a difficult thing to
    carry out. What appears to be dumping can often merely be price discrimination. A firm charges a lower
    price in another country than it does
    for the same product in its home
    country. This would be a perfectly
    logical strategy if the consumers in
    the home country have a lower price
    elasticity of demand than consumers
    in the foreign country. In this case,

    collusion: the practice by rivals
    to limit competition by agreeing not to lower prices or to
    work together to limit entry by
    others

    ?
    2. How do businesses
    attempt to interfere
    with market allocation?

    cartel: an organization of
    independent producers
    that dictates the quantities
    produced by each member
    of the organization

    134

    the firm would increase
    revenue by setting a
    higher price in the
    home country and a
    lower one in the foreign country. This pricing strategy would be
    no different than charging senior citizens
    lower prices for movie
    tickets than the general
    population is charged.
    This is not to say that there are no
    legitimate cases of dumping, but
    many cases involve government subsidies and taxes rather than competition among firms. One case of dumping occurred with sugar produced in
    the European Union (EU) and sold in
    China. The EU provides subsidies and
    protection to sugar producers, who
    then can sell their sugar at prices that
    are below production costs. China
    pointed out that the average produc-

    The EU
    China

    tion cost of sugar in Guangxi is 2,230
    yuan per ton compared with 5,623
    yuan per ton in the EU. But when the
    EU provides a subsidy of 4,127 per
    ton, the EU sugar exporters can sell
    for as low as 1,429 yuan and as high
    as 2,230 yuan and drive Chinese
    sugar producers out of the market.
    The result of the dumping is that
    sugar prices in China have dropped
    by 35 percent, and the amount of
    sugar produced in China has
    declined significantly.

    not to benefit society, although competition might result in that. The goal is to earn
    profit, to restrict competition, limit entry, and charge consumers higher prices.
    Consider two rival firms, A and B, who produce the same good or service. If they
    compete, price is driven down to where it just covers opportunity costs. If they
    agree to keep price high and split the profits, they are both better off. An agreement
    not to reduce prices is called collusion. In order for collusion to be effective, each
    firm has to offer less for sale than each would have in competition. Using the coffee
    shop example from Chapter 6, the initial coffee shop sold 1,000 cups a day at a
    price of $1.50 per cup and earned a positive economic profit of $.70 per cup. Free
    entry drove the price down to $.80 per cup from the initial price of $1.50 as the
    total supply of coffee rose. Suppose the coffee shops decided to cooperate with
    each other and agreed not to sell at lower prices. By doing this, each shop could
    earn some positive economic profit. But, to keep the price high, each shop will
    have to supply less than each would in competition. For instance, if two shops
    agreed to share the market, each would set a price of $1.50 and offer 500 cups of
    coffee. If there were three, four, or five firms, the agreement to keep price high and
    share the market would mean each shop would be able to supply less. If successful,
    though, the competitors together become more like a monopoly, reducing the quantity supplied and keeping the price high.
    An organization of independent firms that attempts to restrict the market supply
    by limiting the quantities each firm offers for sale is called a cartel. To be successful, the cartel has to ensure that each member firm supplies less than what it would
    do if it were not cooperating with the others. The problem with cartels is that each
    member of the cartel has an incentive to increase the quantity it sells, thereby
    cheating on the cartel. For instance, if the cartel price is $1.50 per cup and the
    quantity is 500 cups per firm, then if one firm sells 550 cups rather than 500, it is
    making 50 × $.70 additional economic profit each day. So all firms begin to cheat.
    Part Two / Consumers, Firms, and Social Issues

    As each firm cheats on the agreement just a little, the quantity supplied rises, the
    price drops, and the monopoly disappears.
    A cartel can result from either formal or informal agreement among members.
    Like collusion, cartels are illegal in the United States but occur in other countries. The cartel most people are familiar with is the Organization of Petroleum
    Exporting Countries (OPEC), a group of nations rather than a group of independent firms. During the 1970s, OPEC was able to coordinate oil production in
    such a way that it drove the market price of crude oil from $1.10 to $32 a barrel.
    For nearly eight years, each member of OPEC agreed to produce a certain limited
    amount of crude oil as designated by the OPEC production committee. Then in
    the early 1980s, the cartel began to fall apart as individual members began to
    cheat on the agreement. Members began to produce more than their allocation in
    an attempt to increase profit. As each member of the cartel did this, the price of
    oil fell, reaching $12 per barrel in 1988. Oil prices rose again in 1990 when Iraq
    invaded Kuwait, causing widespread damage to Kuwait’s oil fields. But as repairs
    were made to Kuwait’s oil wells, Kuwait was able to increase production, and oil
    prices dropped.
    Production quotas are not easy to maintain among different firms or different
    nations. Most cartels do not last very long because the members cheat on the agreements. If each producer thinks that it can increase its own production, and thus its
    profits, without affecting what the other producers do, all producers end up producing more than their assigned amounts; the price of the product declines, and the
    cartel falls apart.
    Even though cartels are illegal in the United States, a few have been sanctioned
    by the government. The National Collegiate Athletic Association (NCAA) is a cartel of colleges and universities. It sets rules of behavior and enforces those rules
    through a governing board. Member schools are placed on probation or their programs are dismantled when they violate the agreement. The citrus cartel, composed
    of citrus growers in California and Arizona, enforces its actions through its governing board. Sunkist Growers, a cooperative of many growers, represents more than
    half of the California and Arizona production and also plays an important role in
    enforcing the rules of the cartel.
    facilitating practices: actions
    that lead to cooperation
    among rivals
    cost-plus markup pricing:
    a price set by adding an
    amount to the per-unit cost
    of producing and supplying
    a good or service

    most-favored customer:
    a commitment that the
    customer will receive a
    lower price if anyone else
    receives a lower price

    1.b.1. Facilitating Practices Actions by firms can contribute to cooperation
    and collusion even though the firms do not formally agree to cooperate. Such
    actions are called facilitating practices. Pricing policies can leave the impression
    that firms are explicitly fixing prices, or cooperating, when in fact they are merely
    following the same strategies. For instance, the use of cost-plus markup pricing
    tends to bring about similar if not identical pricing behavior among rival firms. If
    firms set prices by determining the average cost of an item and adding a 50 percent
    markup to the cost, they would be cost-plus pricing. If all firms face the same cost
    curves, then all firms will set the same prices. If costs decrease, then all firms will
    lower prices the same amount and at virtually the same time. Such pricing behavior
    is common in the grocery business.
    Another practice that leads to implicit cooperation is the most-favoredcustomer policy. Often the time between purchase and delivery of a product
    is quite long. To avoid the possibility that customer A purchases a product at one
    price and then learns that customer B purchased the product at a lower price or benefited from product features unavailable to customer A, a producer will guarantee
    that customer A will receive the lowest price and all features for a certain period of
    time. Customer A is thus a most-favored customer (MFC).
    The most-favored-customer policy actually gives firms an incentive not to lower
    prices even in the face of reduced demand. A firm that lowers the price of its product must then give rebates to all most-favored customers; this forces all other firms
    with most-favored-customer policies to do the same. In addition, the MFC policy
    allows a firm to collect information on what its rivals are doing. Customers will

    Chapter 7 / Business, Society, and the Government

    135

    Economic Insight

    eBay and Online Markets

    I

    nternet auctions are attracting increasing numbers of buyers and
    sellers. The most well-known
    company in this online market
    arena is eBay, founded in 1995. On
    any given day, there are millions of
    items listed across thousands of categories. Sellers list an item for a
    small fee, and buyers bid for that
    item. The auctions typically last
    three or four days, and at the end of
    the auction time, the high bidder receives the item. eBay is far from the
    only company offering online auctions. The biggest growth area for
    the online auctions is that between

    businesses. The auto companies
    purchase supplies through an online
    auction; John Deere and other manufacturers purchase supplies
    through online auctions. New
    business-to-business auctions are
    being created every day. The online
    auctions focus most attention on
    price; customers view or read about
    the product and the product’s features and then offer a price. The result is that prices are driven to their
    lowest possible level—much like the
    model of perfect competition.
    What does the online auction
    mean for businesses wedded to

    buildings and face-to-face contact
    with customers? When Wal-Mart
    located in a small town, the local
    businesses were hard-pressed to
    compete with it. They could not
    offer the variety or the low prices
    that Wal-Mart offered. In town after
    town, local businesses attempted
    to keep Wal-Mart from entering.
    Think about what an online auction
    could do. eBay is a rival to virtually
    every store in your city or neighborhood, and there is no way to keep
    eBay from entering.

    return products for a rebate when another firm offers the same product for a lower
    price.
    Consider the behavior of firms that produced antiknock additives for gasoline
    from 1974 to 1979. Lead-based antiknock compounds had been used in the refining
    of gasoline since the 1920s. From the 1920s until 1948, the Ethyl Corporation was
    the sole domestic producer of the compounds. In 1948, Du Pont entered the industry; PPG Industries followed in 1961, and Nalco in 1964. Beginning in 1973, the
    demand for lead-based antiknock compounds decreased dramatically. However,
    because each company had most-favored-customer clauses, high prices were maintained even as demand for the product declined.
    A most-favored-customer policy discourages price decreases because it requires
    producers to lower prices retroactively with rebates. If all rivals provide all buyers
    with most-favored-customer clauses, a high price is likely to be stabilized in the
    industry.
    We’ve seen that firm behavior can be understood as an attempt to maximize
    profit. But firms are not always free to do what they believe will maximize profit.
    The government defines rules of behavior and limits many actions that firms would
    otherwise undertake. In the next sections we discuss the involvement of government in the affairs of business.

    1.c. Antitrust

    monopolization of a market:
    market dominance by one firm
    gained unfairly

    136

    When a firm or group of firms turns a market from a perfectly competitive one to
    one that is a monopoly, the price is higher and quantity lower than would be the
    case with competition and free entry. The government attempts to limit business
    practices that restrict competition by defining certain business practices to be
    illegal. Antitrust laws are designed to prevent what is called the monopolization
    of a market—the attempt to unfairly restrict or bar entry by rivals. The problem
    is how to tell if an action unfairly restricts entry. It is straightforward to state
    that collusion and cartels are illegal. But, is an agreement by Kinkos to use only
    Kodak paper competitive or anti-competitive? Is a low price competitive or anticompetitive if it drives some firms out of business? Does Wal-Mart use unfair
    practices to compete against the small mom-and-pop stores in towns that Wal-Mart

    Part Two / Consumers, Firms, and Social Issues

    antitrust: laws that restrict
    large dominant firms from
    behaving anticompetitively.

    Now You Try It
    What is the difference
    between monopoly and
    monopolization?

    locates in? Is Apple acting unfairly by not making iPods compatible with other
    MP3 player systems? Is the merger of two big office stores a way for the stores
    to experience economies of scale and thus be more efficient or is it a way to
    dominate the market and behave like a monopolist? These and many other controversial issues often are the central feature of lawsuits and antitrust laws. Antitrust
    refers to the laws that restrict “trusts”, large dominant firms, from behaving anticompetitively.
    In the 1960s, computers were sold or leased as complete systems, combinations of
    central processing units and peripherals—tape drives, disk drives, programs, and
    other components. A Control Data disk drive did not provide direct competition for
    an IBM disk drive because the Control Data unit would not work with the IBM central processing unit and software. In the late 1960s, several companies developed tape
    and disk drives that were compatible with the IBM units. This allowed the companies
    to sell the peripherals in direct competition with IBM, forcing IBM to respond to
    competition on each piece of equipment as well as on the entire system. This reduced
    IBM’s ability to control price and output in the peripherals market, but because the
    peripheral companies could not produce a compatible central processing unit, IBM
    retained the ability to control price and output in the systems market. So IBM
    dropped the price of its peripherals to the point at which the other firms could not
    compete and retained its higher price on the central processing unit. It was taken to
    court for its actions. After several years and millions of dollars, IBM won the right to
    continue its actions. By this time, the compatible peripherals had been manufactured
    by several companies.
    The traditional telephone market is divided into long distance and local. The
    long-distance market is a competitive market today, with many firms entering and
    offering service. In fact, there are about 400 long-distance telephone companies
    operating in the United States today. This was not always the case. Prior to 1984,
    the long-distance market was controlled by a single firm, AT&T, and that firm was
    regulated by the government. The government dictated telephone rates and service.
    In 1984, the government decreed that AT&T had to be broken into what is now
    AT&T (the long-distance company) and seven local calling companies, known
    today as the regional Bell operating companies. The long-distance market was
    deregulated. The government allowed any firm that wanted to offer long distance to
    enter the market and offer the service. The government gave up trying to dictate
    rates and service. As a result, hundreds of new companies entered the market, and
    long-distance prices have declined by about 70 percent.
    In each of the seven regions, the regional Bell operating company has over 90
    percent of the local calling market. State governments regulate the regional Bell
    company operating in the state and dictate prices and service requirements. The
    success of deregulating the long-distance market induced Congress to attempt to
    deregulate the local market. The Telecommunications Act of 1996 was supposed to
    create a competitive market in local calling, but to date local calling remains dominated by the regional Bell operating companies.
    Beginning in the 1980s, Microsoft has been under government scrutiny. The
    1980s scrutiny of Microsoft was based on the claim that the operating system
    owned by Microsoft was so dominant that it allowed Microsoft to charge much
    higher prices than would occur in a competitive market with free entry. The 1990s
    argument against Microsoft was that Microsoft required computer manufacturers
    and retailers to include its Internet browser with each personal computer, thereby
    precluding other firms like Netscape from competing in the market. In the 2000
    complaints, Microsoft was accused of unfairly bundling or combining its software
    in an attempt to restrict competition. In 2002, Microsoft agreed to license its technology so that other producers could produce equipment that would seamlessly
    communicate with Windows. In 2003, several nations undertook antitrust action
    against Microsoft and others followed in 2004.

    Chapter 7 / Business, Society, and the Government

    137

    The government also scrutinizes the price strategies of large firms. The government has been involved in several cases of predatory pricing. It is argued that a firm
    will sell a product below its costs to try to drive another firm out of business for the
    sole purpose of then raising the price to excessive levels later. Predatory pricing has
    proven to be a difficult case for the government to win. Not only must the firm sell
    below its own cost, but it must then create significant barriers to entry if it is to
    raise its price to “excessive” levels. Without the barriers to entry, once the predatory firm earns positive economic profit, other firms will enter and again compete
    with the predatory firm.
    Price discrimination comes under international scrutiny on a regular basis. The
    World Trade Organization, the international agency involved in business behavior,
    has examined many cases in which an industry in one country accuses competitors
    in another country of dumping. For instance, U.S. industries have filed claims of
    dumping against South African manufacturers of steel plate; against German, Italian, and French winemakers; against Japanese manufacturers of semiconductors;
    against Singapore; and against 19 steel-producing nations.

    1.d. Economic Regulation

    regulation: the control of
    some aspect of business by
    the government
    natural monopolies: when
    economies of scale lead to
    just one firm

    R E C A P

    138

    Antitrust laws set rules of behavior for large firms. In many industries, the government does more than simply set the rules of behavior. Often it intervenes in the operation of the business, dictating the price that can be charged or the areas that can
    be or have to be served. In some cases, the government actually pays for and produces the good or service—public education, for instance. These types of intervention are referred to as regulation.
    The government has regulated some industries because of the argument that the
    industries are natural monopolies. A natural monopoly is one that would arise
    because the industry consists only of economies of scale. With economies of scale
    the largest firm could set a price below that which any smaller firm would need to
    charge to stay in business. The market would have just one firm—a monopoly. For
    many years following the industrial revolution, it was argued that the railroads
    were natural monopolies. Thus, the government has been involved in the railroad
    industry for more than 100 years. Electric utilities have been regulated because of
    the argument that they are natural monopolies as have airlines. The argument for
    regulating airlines was to create orderly growth and avoid a natural monopoly. From
    the mid-1930s to the mid-1970s, the Civil Aeronautics Authority and its successor,
    the Civil Aeronautics Board (CAB), controlled entry into the airline industry. Each
    airline was restricted to specific routes. For example, United Airlines was authorized to serve north–south routes on the West Coast, and Delta and Eastern served
    such routes on the East Coast.

    1. Firms would rather be monopolists than perfect competitors. If they can limit
    competition, they can charge higher prices, and they can earn positive economic profits. There is an incentive for firms to cooperate in an attempt to
    limit competition.
    2. Collusion is the practice by rivals to limit competition. They agree not to
    lower prices or to work together to limit entry by others.
    3. A cartel is an organization of formerly independent firms for the purpose of
    controlling the quantity supplied and the price.
    4. A cartel can effectively keep the price high only by restricting quantity. This
    creates an incentive for each member to attempt to sell more than their

    Part Two / Consumers, Firms, and Social Issues

    allocated quantity at the high price. As the supply increases, the price is decreased and the cartel falls apart.
    5. Firms may cooperate implicitly by their behaviors. Implicit collusion is called
    a facilitating practice.
    6. The government sets rules of business behavior with antitrust laws. It is illegal to form cartels or to collude. Other practices often have to be decided in
    courts or by the Justice Department or the Federal Trade Commission.
    7. In some cases, the government dictates what price firms can charge, the
    quantity they have to supply, and other aspects of business. This is called
    economic regulation.

    2. MARKET FAILURES

    ?

    The market does not work efficiently or does not allocate resources to their highestvalued uses in some circumstances. For instance, highways become littered with
    garbage because no one has to pay for littering. Roads become congested because
    no one has to pay to use the highway. Air becomes polluted because no one pays for
    emitting pollutants. Animals and plants become endangered because no one can buy
    or sell them. These problems are referred to as market failures.

    2.a. Externalities
    3. What are market
    failures?

    The decision to purchase an SUV affects others. The emissions for an SUV are
    larger than those for a small car or a hybrid battery–gasoline car. In addition, if a
    collision between an SUV and a small car occurs, the inhabitants of the SUV are
    much less likely to be injured. Yet, the effects on pollution or the environment created by those emissions that affect everyone are not the responsibility of the SUV
    owners. The SUV owners don’t have to compensate the small car owners for
    putting their lives at risk nor pay for the additional pollution. The problem is that
    people who are not voluntarily part of the transaction to purchase the SUV have to
    bear these costs—you or me or anyone who does not own an SUV.

    Chapter 7 / Business, Society, and the Government

    139

    externalities: a cost or benefit
    created by a transaction that
    is not paid for or enjoyed
    by those carrying out the
    transaction

    Because the people who are not part of the decision to purchase and drive the
    SUV must bear costs of that transaction, these costs are called externalities. The
    problem created by externalities is that the price of the private transaction does not
    reflect all the costs of the items involved in that transaction. If it did, the price of
    SUVs would be higher and fewer would be purchased. This means that too many
    SUVs are driven and too much pollution created. The too many and too much refer
    to the quantities that would occur if there were no external costs. So, the market is
    not working to allocate resources to their highest-valued uses. Too many are being
    used in creating and selling SUVs and too few in other activities.
    In Figure 2 the market for SUVs is illustrated. The demand for them is D and the
    supply is SP. The “p” represents the private costs. This does not include the costs
    created by the SUV in terms of risk to smaller vehicles or increased emissions. The
    equilibrium quantity and price are depicted as Qp and Pp. If the external costs were
    included in the cost of supplying the SUV, then the supply would be Ss. As a result,
    the quantity purchased would be less, Qs rather than Qp, and the price would be
    higher, Ps rather than Pp.
    McDonald’s sells its drinks in plastic or Styrofoam cups. Customers discard
    the cups, often simply throwing them out of the car window. Neither McDonald’s
    nor the customers pay for cleaning up the trash. Society as a whole has to pay the
    costs of cleaning up the trash; those who threw the trash out the window and
    the McDonald’s outlet that put the food and drinks in the plastic containers pay no
    more than anyone else.
    Externalities can be positive or negative. If they are negative, they impose
    costs on others; if they are positive, they grant benefits to others. There are 1.5
    million cars stolen in the United States each year. An antitheft device called
    LoJack was first introduced in Boston in 1986 and is now available in most major
    metropolitan areas. Usually sold to new car purchasers by car dealers for a onetime fee of about $600, the LoJack system involves a small radio transmitter that
    is hidden in the car. If the car is reported stolen, the police activate the transmitter
    by remote control with high-tech equipment provided by the company. About
    95 percent of stolen vehicles equipped with LoJack are recovered. By leading
    police directly to stolen cars, LoJack helps them to shut down “chop shops” that
    dismantle vehicles for resale of parts. Professional car thieves have no way of
    knowing whether a car is armed with LoJack. As a result, it is estimated that one

    Figure 2
    Ss

    Negative Externality

    Sp
    Price of SUVs

    The demand for SUV is D and
    the supply is Sp. The externality means higher costs than
    reflected in the supply. If the
    externality was internalized,
    then the supply would be Ss
    and price would be higher Ps,
    rather than Pp, and the quantity sold smaller, Qs rather
    than Qp.

    Ps
    Pp

    D

    Qs Qp
    Quantity of SUVs

    140

    Part Two / Consumers, Firms, and Social Issues

    private property right: the
    right to claim ownership of
    an item

    internalized: a situation when
    what was an external cost is
    paid for by the parties creating
    the cost

    auto theft is eliminated annually for every three LoJack systems that are installed.
    Thus, the benefit to society in terms of less overall auto theft—benefits such as
    lower insurance costs—exceeds the benefit to the individual owners who install
    the LoJack system. Society benefits by the sum of the benefits each owner who
    installs a LoJack system receives and the reduced insurance costs everyone
    receives.
    Another positive externality is created by vaccination programs, such as those
    for the flu. It takes time to get a shot. If often costs and often hurts, so many people
    choose not to get the vaccine. As long as enough people get the vaccine, then someone who doesn’t is less likely to come down with the flu. He benefits from all those
    who do get the vaccination.
    Externalities refer to situations in which not all costs or benefits are included in
    a transaction. In other words, people not involved in the transaction receive a benefit or a cost from the transaction. If not all costs and benefits are included in a transaction, then resources may not be allocated to their highest-valued uses. In the case
    of a negative externality, more resources go into the activity than if the external
    cost was accounted for. For instance, more Styrofoam cups are produced and sold
    than if McDonald’s and/or customers had to pay the additional cost of cleanup for
    the discarded cups. In the case of a positive externality, not enough resources go
    into the activity. For instance, if all of the benefits of the LoJack system were provided only to the individual buyers, the buyers would receive a lower price and
    more LoJack systems would be installed.
    Some activities have both positive and negative externalities. Smoking is
    claimed to be one such activity. Secondhand cigarette smoke is an irritant and bothers some people a great deal — a negative externality. The American Lung Association says that the average smoker dies seven years earlier than the average nonsmoker. This might be viewed as a positive externality in that these people won’t
    live long enough to enjoy Social Security or receive society-provided health care.
    Nonsmokers get to share the funds left by smokers.
    Every activity has associated positive and/or negative externalities. A simple action such as purchasing milk at a grocery store has many externalities associated
    with it. By standing in the grocery line, you impose costs on others who have to
    wait for you to make your transaction. Also, by purchasing the milk you are expressing to the store your desire for the store to carry that brand of milk; this benefits others who also want to have the milk available. Every innovation and invention creates jobs and new industries. These are positive externalities. At the same
    time, the innovation and invention replace now obsolete jobs and industries,
    thereby driving them out of business. These are negative externalities.
    Are all of these externalities distortions of the market, that is, inefficient uses of
    resources? If you love gardening and thus create a beautifully landscaped front
    lawn that provides benefits to people just passing by, will you stop doing the gardening because the people passing by don’t pay you for the benefits they receive?
    Although a positive externality is created, it is not sufficient to alter the amount of
    gardening that occurs.
    Nobel Laureate Ronald Coase did not necessarily see externalities as market
    failures. He saw the problem as one of private property rights (ownership). If private property rights are well defined, then the externality often can be resolved
    through private negotiation. Consider how Coase might describe the following situation. One neighbor, Bob, liked to play his music late into the night. Another neighbor, Rosa, was an early-to-bed early-to-rise person. The music was an externality to
    Rosa. If Bob owned the right to play the music, Rosa would have to work something out, perhaps by improving sound proofing in her house or paying Bob not to
    play the music. If Rosa owned the right to quiet, then Bob would have to play the
    music less loudly or pay Rosa to allow him to play it loudly. In either case, once
    someone has the property right, the externality is solved; it is said to have been
    internalized.

    Chapter 7 / Business, Society, and the Government

    141

    2.b. Common Ownership
    Common ownership is another case where the market is not able to efficiently allocate goods and services, as illustrated in this simple story about four people named
    Everybody, Somebody, Anybody, and Nobody. There was an important job to be
    done, and Everybody was sure that Somebody would do it. Anybody could have
    done it, but Nobody did it. Somebody got angry about that because it was Everybody’s job. Everybody thought Anybody could do it. But Nobody realized that
    Everybody wouldn’t do it. The end result was that Everybody blamed Somebody
    when Nobody did what Anybody could have. When nobody owns something, nobody takes care of it. When somebody owns something, somebody takes care of it.
    When everybody owns something, nobody takes care of it.
    Chickens and cows are not on the endangered species list, but elephants and
    rhinos are. Why? No one owns the elephants and rhinos. The result is that they are
    overutilized—they are becoming extinct. In most nations with elephants, large
    national parks have been created in which hunting is forbidden. But even in the
    face of these bans on hunting, the reduction in the number of elephants has continued in most of the African nations. Government allocation of resources by creating
    common ownership does not solve a problem of common ownership. In contrast
    to the common ownership strategy, the governments of Botswana, Zimbabwe, and
    South Africa created private property rights by allowing individuals to own elephants. These elephant farmers ensure that the elephants breed and reproduce so
    that they can be sold for their tusks, for hunting in special hunting parks, or to zoos
    in developed nations. This has led to a revival of the elephant population in these
    nations.
    Common ownership or lack of private property rights means the market cannot
    work. If you don’t own something, you can’t sell or trade it. The creation of private
    property rights creates the ownership necessary for markets to function.

    2.c. Some Goods Don’t Fit the Market: Public Goods
    public goods: a good that is
    not excludable and is not
    rivalrous
    free rider: a consumer or
    producer who enjoys a good
    or service without paying for it

    142

    If something is available for you to use and you don’t have to pay for it, why would
    you pay? That’s the problem with what economists call public goods: people can
    get these goods without paying for them. When goods are public, an individual has
    an incentive to be a free rider—a consumer or producer who enjoys the benefits of
    a good or service without paying for that good or service. As an example, suppose
    that national defense was not provided by the government and paid for with tax
    money; instead, you would not be protected by the armed forces unless you paid a
    fee. A problem would arise because national defense is a public good; you would
    be protected whether or not you paid for it as long as others paid. Of course, because each person has an incentive not to pay for it, few will voluntarily do so, and
    so the good may not be provided, or, if it is provided, the quantity produced will be
    “too small” from society’s viewpoint—that is, from what would have occurred had
    private property rights been well defined.
    Public goods have two properties that provide problems for markets. The first
    property is called nonrivalry in consumption; the second is called nonexcludability.
    An example of a nonexcludable public good is national defense—if one person in
    an area receives it, all do. Television broadcasts are an example of a nonrivalrous
    good. When one person views a television show, the signal to others does not
    diminish.
    Since one person’s purchases are automatically available to all (in the nonexcludable case), there is a temptation to free-ride on others’ contributions. If freeriding is extensive, no one has an incentive to offer a good for sale. This may
    explain why national defense is a function for government. If the government did
    not provide it, no one would.

    Part Two / Consumers, Firms, and Social Issues

    2.d. What We Don’t Know Can Hurt Us: Asymmetric
    Information

    adverse selection: a situation
    where a lack of information
    causes low-quality items to
    dominate a market and highquality items to be driven out
    of the market

    moral hazard: a situation
    where imperfect information
    provides an incentive for a
    consumer or producer to
    change behavior after agreeing
    to a specific behavior

    ?
    4. How might market
    failures be corrected?

    You see a car with a for-sale sign on the corner. You contact the owner, ask about
    the car, drive it, and decide to purchase it. A month later the car fails to work and
    you find out it is not repairable. You have been taken. Because of such a risk, if you
    ever purchase a used car, you won’t pay much for it. In general, because people
    don’t know much about the used cars offered by private individuals, those cars
    command very low prices. This means that anyone wanting to sell a used car in premium condition is not going to get what the car is really worth. High quality used
    cars are traded in or transferred among friends and family. As a result, the only
    used cars in the market are lemons.
    This is called an adverse selection problem — bad quality drives good quality
    out of the market. Another example often suggested exists in lending markets.
    Lending institutions do not know whether a potential borrower is a good risk or
    not. So to be sure to cover risks and expenses, the lender increases the interest rate
    on the loans provided. As the interest rate is increased, low-risk borrowers drop out
    of the market. It is the high-risk borrowers who remain in the market. The lender is
    in a quandary; if the interest rate is lowered, all borrowers — low and high risk —
    seek loans. If the lender increases the interest rate, low-risk borrowers drop out of
    the market, leaving just the high-risk borrower.
    A second form of market problem created by informational asymmetry is called
    moral hazard. Suppose you purchase a new car; you drive safely until you get insurance. Once you have insurance, you drive recklessly because if anything happens, your new car is covered. This change in your behavior is called moral hazard.
    If the insurance company has no information about your driving behavior after selling you insurance, the company is unable to charge you what would be commensurate with your riskier behavior.
    Asymmetric information can create problems for markets. If the bank cannot
    know whether people applying for a loan are high or low risk, it may not find it
    worthwhile to provide loans. If the company cannot judge whether you will change
    behavior in an adverse way once you get the insurance, it may not offer insurance.

    2.e. Market Problems and the Government
    Private property rights are necessary for a market to exist and work. When private
    property rights are not defined or are ambiguous, goods and services may not be allocated to where they have the highest value. In such situations, there are incentives
    for a solution to be devised. There are several potential solutions to these market
    problems.
    Private negotiation between affected parties could solve or internalize an externality problem. Private property rights would have to be well defined and negotiation would have to be possible. Similarly, the common ownership problem could be
    resolved by creating and assigning private property rights. The assignment of rights
    might not be very easy, however. It could be difficult to identify the relevant parties, bring them together to negotiate, establish the terms, and then enforce the
    agreement. With just two parties, Bob and Rosa, there was no problem getting together and discussing the issue. But consider the difficulty of getting every SUV
    owner to meet and agree on proper ways to solve pollution problems and the risk of
    injury in collisions.
    Due to the difficulty of arranging private negotiation, it is often left to government to reduce an externality problem. One approach that the government uses is to
    impose a tax on or provide a subsidy for those creating the externality. Consider the
    SUVs again. If the government imposed a tax on SUVs, based on the amount of
    pollution the firm created, buyers would have to consider the extra cost when de-

    Chapter 7 / Business, Society, and the Government

    143

    Now You Try It
    An immunization that prevents
    cancer is now available. It protects against human papillomavirus (HPV) infection,
    which is responsible for virtually all cases of uterine cervical
    cancer. HPV is the only known
    virus that is the sole cause of a
    specific cancer. The Centers
    for Disease Control and Prevention recommends immunization for all girls 11 to 12
    years old, before the age
    women become sexually active.
    The vaccine is FDA-licensed
    for women and girls ages 9 to
    26 and is also CDC-recommended for women already
    sexually active or who have
    Pap smear abnormalities. Research continues on the immunization of males. Controversial legislation has been
    introduced in some states to
    create a school requirement for
    inoculation of sixth-grade girls.
    If it becomes law, can it be explained as a government solution to a market failure problem? Explain.

    ciding whether to purchase the vehicle. The tax is a way in which the government
    can force the polluter to internalize the externality, that is, to pay for it rather than
    have society pay for it. In Figure 2(a), a tax on the SUV equal to the amount of the
    external costs is illustrated by the shift from the private supply curve to the social
    supply curve; the tax would cause the supply curve to shift in from Sp to Ss. The tax
    would reduce the quantity of SUVs purchased and internalize the costs of the externalities. In other words, SUV buyers would pay for the increased costs that owning
    a SUV creates for others.
    In the case of a positive externality, the government might provide a subsidy
    rather than impose a tax. Suppose each person getting an inoculation is given some
    money. More people would be willing to be inoculated. The subsidy induces buyers
    to increase the quantities that they are willing and able to buy at each price.
    The problem with taxes and subsidies is that those setting the taxes and subsidies (the government, in most cases) must guess at what the socially optimal level
    would be. A tax that is too high will create an inefficiency of too little production; a
    tax that is not high enough will do the opposite.
    The government could simply outlaw SUVs or, in the case of the positive externality of vaccines, it might mandate that all children under the age of six be inoculated. But the command approach leads to too few SUVs or too many people to be
    inoculated.
    In a few cases, the government has attempted to find a market solution to
    externality problems. For instance, the government defines the quantity of pollutants it will allow in a particular area. Permits that enable the owners of the permits to pollute are then issued. For example, if the target pollution level in the Los
    Angeles basin is 400 billion pounds of particulates per day, the government could
    issue a total of 400 permits, each permitting the emission of 1 billion pounds of
    particulates per day. Then the government could sell the permits. Demanders, typically the polluting firms, would purchase the permits, allowing them to pollute up
    to the amount specified by the permits they own. If a firm purchased 20 permits, it
    could emit up to 20 billion particulates per day. If that firm implemented a cleaner
    technology or for some other reason did not use all of its permits, it could sell
    them to other firms. The resulting price would be an equilibrium — where traders
    are comparing the cost of purchasing permits to the costs of implementing cleaner
    technologies.
    If the amount of pollution allowed is reduced, then fewer permits are issued. Demanders bid for the now fewer pollution permits, driving the price of the permits
    up. As the price rises, some firms will decide not to purchase the permits, but instead to purchase new pollution abatement equipment or to reduce the amount they
    produce.
    The higher price gives firms an incentive to adopt more efficient pollution abatement equipment. The permit market also enables others to influence the total
    amount of pollution created. Anyone can purchase permits. A few people might try
    to make money by buying and selling permits. If you expect the price of the permits to rise in the future, you might purchase the permits now, hoping to sell them
    later. If the price does rise, the owners of the permits will be able to sell them for a
    gain. Others purchase permits in order to control the quantity of pollution. Environmental groups, such as the Nature Conservancy and the Sierra Club, have purchased permits and taken them out of circulation. In this way, they reduce the total
    number of permits in circulation and thus reduce the total amount of pollution
    permitted.

    2.e.1. Social Regulation
    Although economists debate the costs and benefits of regulation, the amount of regulation has grown steadily since the Great Depression. Most of this growth has been

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    Part Two / Consumers, Firms, and Social Issues

    social regulation:
    government regulation
    of health, safety, the
    environment, and
    employment policies

    due to what is called social regulation, rather than economic regulation. Social
    regulation is concerned with the conditions under which goods and services are
    produced and the impact of these goods on the public. The following government
    agencies are concerned with social regulation:
    The Occupational Safety and Health Administration (OSHA), which protects workers against injuries and illnesses associated with their jobs.
    The Consumer Product Safety Commission (CPSC), which specifies minimum standards for the safety of products.
    The Food and Drug Administration (FDA), which oversees the safety and effectiveness of food, drugs, and cosmetics.
    The Equal Employment Opportunity Commission (EEOC), which focuses
    on the hiring, promotion, and discharge of workers.
    The Environmental Protection Agency (EPA), which controls air, water, and
    noise pollution.
    The government has become increasingly involved with the health and safety of
    the workplace, the human resource policies of business (compensation, pensions,
    harassment, evaluation, stress, and so on), and the environmental consequences of
    business activities.
    Most of the arguments made in support of social regulation are based on
    the idea that the regulation will aid the public. Over 10,000 workers die in
    job-related accidents in the United States each year. Air pollution is a problem in
    many cities, leading to cancer and other diseases, which in turn mean increased
    demands on health-care agencies. Hundreds of children are killed each year as a
    result of poorly designed toys. Unfair discharges from jobs, discrimination, and
    sexual harassment occur frequently. It is argued that without government regulation, these events would be much more serious and would impose tremendous costs
    on society.
    There are costs to the regulation, however. It is expensive to administer the agencies and enforce the rules and regulations. The annual administrative costs of federal regulatory activities exceed $15 billion. The cost to business of complying
    with the rules and regulations has been estimated to exceed $300 billion per year.
    Complying with environmental regulations alone costs business more than $200
    billion per year.
    Added to the direct costs of regulations are the opportunity costs. For instance,
    the lengthy process for approving new biotechnology has stymied advances in
    agriculture. Regulatory restrictions on the telecommunications industry have resulted in the United States lagging behind Japan in the development of fiber optics
    and high-definition television. The total cost imposed on the U.S. economy from
    federal government regulations is estimated to be more than $600 billion a year,
    $6,000 per household.
    Are the regulations worth the costs? To answer this question, we need to
    compare the costs and benefits of each regulation. But this can be a difficult
    proposition. It may require us to answer this question: How much is a life
    worth? Simply asking the question offends many people. But answering the
    question is what economists think is necessary if regulation is not to benefit
    only special interest groups. To economists, life is worth what people are willing
    to pay to stay alive. Of course, that differs from person to person, but the values
    could be used to place limits on what regulations to implement. For instance, using the extra pay that people require to take dangerous jobs or calculating the total value of expenditures on smoke detectors and safer cars could provide estimates of how much people value life. Although the estimates vary widely, none
    exceed $10 million. Some economists thus argue that any regulation costing

    Chapter 7 / Business, Society, and the Government

    145

    Now You Try It
    Which of the following regulations would be implemented based on a cost/benefit
    calculation?
    Grain dust

    saves 4 lives per year at a cost of $5.3 million per life

    Copper smelters

    save .06 life per year at a cost of $26 million per life saved

    Formaldehyde

    saves .01 life per year at a cost of $72 billion per life saved

    more than $10 million per life saved should not be implemented. For instance,
    rules on unvented space heaters save lives for just $130,000 each whereas regulations on asbestos removal exceed $100 million per life saved. According to a
    comparison of costs and benefits, the first rule should be implemented, but the
    second should not.
    The cost-benefit test for regulation would limit regulations designed to benefit a
    very few at the cost of many. However, the cost-benefit test also should include the
    opportunity costs implied by interfering with the free market, according to many
    economists. If seat belts and antilock braking systems are desired by the public,
    won’t the public voluntarily pay the price to have these safety systems? Why, then,
    is regulation necessary unless it is to benefit some special interest group?

    2.e.2. Is Government Necessary?
    When so-called market failures exist, is it necessary to have the government serve
    as the allocating mechanism? Private actions can resolve market failure problems
    in many cases. Building large stadiums around baseball or football fields restricts
    the viewing of the games from outside the stadiums—you have to purchase a ticket
    to see the contest. Without the stadiums, the games would be available for anyone
    to watch—for free—and no one would pay to watch.
    Asymmetric information issues may also be resolved by the proper definition of
    private property rights. Adverse selection and moral hazard problems are primarily
    problems of ambiguous ownership of property rights. Who owns the information
    that is necessary and how is that information to be provided in the market? When
    moral hazard or adverse selection exists, there may be an opportunity for someone
    to profit from providing information. Carfax provides the history of a car for a fee.
    Equifax and other credit agencies provide individual credit histories for a fee.
    These firms illustrate that the market can often solve what is called a market failure
    problem. When the missing information can be privately provided, the market failure problem disappears.
    Sometimes a moral hazard problem can be reduced by having the person or firm
    creating the hazard and the person or firm being taken advantage of share in the
    costs. This is a reason that insurance companies require a deductible and banks and
    other lending institutions require a down payment: so that the company and the
    customer share in the expenses and risks. You are more likely to drive carefully and
    safeguard your health if you have to pay some of the costs of an accident or illness.
    Similarly, if you must pay a copayment, you are less likely to behave in a way that
    causes you to bear a large number of such copayments.
    Although turning to the government to solve market problems might make sense
    theoretically, it can have practical problems. We have discussed several possible
    types of market failure. For each, there are usually two types of solution. In one,
    the government is only minimally involved. In the other, the government does
    everything. For instance, if the government can assign private property rights to an
    externality problem, the problem can be solved privately. But if private property

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    Part Two / Consumers, Firms, and Social Issues

    ?
    5. What are government
    failures?

    logrolling: legislators support
    one another’s projects in order
    to ensure support for their
    own.

    rights cannot be assigned, then the government may have to command that businesses and individuals behave in specific ways. Similarly, a public good might be
    provided privately and financed by government, or the government might have
    to provide it and pay for it. Because the government is so involved in these market
    failure issues, we have to evaluate how efficiently the government can do the
    job. Whereas it is one thing to argue that a market failure cannot be resolved privately, it is quite another to argue that the inefficiency created by the failure
    is worse than the inefficiency of having the government try to solve the problem.
    At least, this is what James Buchanan, who received the 1986 Nobel Prize in
    economics, argues.
    Inefficiencies with government allocation often arise not because legislators are
    incompetent or ignorant, but because of problems with individual incentives. Consider, for instance, the senator from Arizona who wants to reduce government
    spending, so he votes no on all spending bills. The result is that Arizona residents
    do not get federal government money to build highways and bridges, while the residents of those states with senators who aren’t as conscientious as the Arizona senator receive federal government dollars for their bridges and roads.
    The behavior of the senators is similar to the situation facing a group of diners
    who are going to split the bill for the dinner equally. Herb and nine friends are having dinner at Chimichangas in Phoenix. To simplify the task of paying for their
    meal, they have agreed in advance to split the cost of their meal equally, with each
    paying one-tenth of the total check. Herb recognizes that if he orders more expensive items than the others, he will be gaining at the expense of his nine friends. So
    he orders appetizers, the most expensive entree, and the most exorbitant dessert and
    drinks. The problem is that each of his nine friends recognizes the same thing. Each
    orders far more than he would if he were dining alone. As a result, the total bill
    rises.
    Legislators will support one another’s special or so-called pork-barrel programs,
    causing total government spending to rise significantly. Consider a voter in a congressional district that contains one one-hundredth of the country’s taxpayers. Suppose that district’s representative is able to deliver a public project that generates
    benefits of $100 million for the district, but costs the government $150 million. Because the district’s share of the tax bill for the project will be only $150 million/100
    = $1.5 million, residents of the district are $98.5 million better off with the project
    than without it. And that explains why so many voters favor legislators who have a
    successful record of “bringing home the bacon.”
    Why would legislator A support such a project in legislator B’s home district?
    After all, B’s project will cause A’s constituents’ taxes to rise by a small amount,
    while they get absolutely no benefit. The answer is that if A does not support B’s
    project, then B will not support A’s. The practice of legislators supporting one another’s projects is called logrolling.
    A primary cause of inefficiency in government is that the gains from government projects are often concentrated in the hands of a few beneficiaries, while the
    costs are spread among many. This means that the beneficiaries have an incentive
    to organize and lobby in favor of their projects. For example, in the 1990s, the Cosmetology Association in many states lobbied the state legislators to require more
    stringent licensing requirements for manicurists. The reason for the lobbying was
    the number of new spas and salons that were being established by immigrants.
    These spas were driving prices down; some of them were offering manicures for
    $10 rather than the $25 charged at the established spas. If manicurists were required to go to school for six months, the number of new spas that would open for
    business would decline, and prices at established spas could be upheld. The laws
    benefited the existing cosmetologists at the expense of new upstart manicurists.
    Although the Cosmetology Association was willing to devote resources to its lobbying effort, no group opposed the legislation.

    Chapter 7 / Business, Society, and the Government

    147

    Who gains with government intervention and who loses? There is a debate
    among economists over this issue. On one side, it is argued that without the government’s monitoring and limiting the behavior of large firms, markets would be dominated by one or a few firms, and consumer surplus would be minimal. On the other
    side, it is argued that the government intervenes not to improve efficiency but to
    provide benefits to special interest groups. Opponents of regulation argue that the
    natural monopoly and chaos arguments are not valid. They point out that most government regulation has been undertaken to protect special interests—the railroad
    barons, for example. When trucking became a direct competitor to the railroad, the
    government placed the trucking industry under regulation. Trucking was regulated
    not because it was a natural monopoly but because years of regulation had put railroads at a disadvantage relative to trucking.

    R E C A P

    148

    1. Often when the outcome of a market exchange is not favorable to specific
    individuals or groups, these individuals or groups attempt to change the allocation to something other than the market.
    2. The market may be less efficient than other allocation mechanisms in certain circumstances. These are referred to as market failures.
    3. Market failures include externalities, public goods, and asymmetric information. In these cases, the ownership or private property rights are not well
    defined.
    4. When private transactions create costs or benefits that are not borne by the
    participants in that transaction, an externality occurs. Externalities may be
    negative or positive.
    5. When something is not owned, it is called a common or public good. Public
    goods have two properties that provide problems for markets. The first
    property is called nonrivalry in consumption; the second is called nonexcludability.
    6. When buyers and seller have different amounts of knowledge about their
    private transaction, there is an asymmetric information problem. Adverse
    selection occurs when the asymmetric information forces the high quality
    good or service out of the market. Moral hazard occurs when behavior
    is changed once an agreement has been made relying on preagreement
    behavior.
    7. Market failures mean that either too many or too few resources are allocated
    to goods and services; resources are not allocated to their highest-valued
    uses.
    8. When individuals or groups do not like market outcomes and/or when market outcomes are not efficient, a government allocation is instituted.
    9. Having the government resolve market failure problems may impose greater
    costs on society than if the government did not try to resolve the problems
    due to government inefficiency.
    10. Government inefficiencies result from the legislative process, from the
    incentives of politicians, and from benefits being allocated to special
    interests.
    11. Which is worse, market failure or government failure? Some support government solutions and others market solutions.
    12. The type of solution to implement or whether to implement an intervention
    in the market depends on a cost/benefit calculation.

    Part Two / Consumers, Firms, and Social Issues

    SUMMARY
    ?

    1.

    2.

    3.

    ?

    3.

    4.

    5.

    6.

    ?

    7.
    8.

    Why don’t people like market allocation?

    The market allocates resources to their highest-valued
    use. In the market, those willing and able to pay for a
    good or service get the good or service; those not willing or not able are left without.
    Creative destruction means some people and some resources get displaced, thrown out of jobs, or left out
    of activities.
    The market may fail to allocate resources to their
    highest-value use in certain circumstances.
    How do businesses attempt to interfere with
    market allocation?

    A monopoly charges a higher price and sells a lower
    quantity than a market with competition and free entry. This allows the monopolist to earn a positive economic profit.
    Collusion is the practice of independent businesses
    agreeing to fix prices or jointly carry out some other
    activity.
    A cartel is an organization of formerly independent
    companies (or nations) that work like a monopoly, restricting output and raising price.
    Antitrust law is the government’s attempt to minimize
    the negative impacts of cartels, collusion, and other
    unfair business practices on society. Cartels and collusion are illegal. Other practices are scrutinized by the
    Justice Department and Federal Trade Commission
    and are the subject of lawsuits.
    What are market failures?

    A market failure occurs when the market does not allocate resources to their highest-valued use.
    An externality occurs when some costs or benefits
    created by a private transaction are not accounted for
    in the private transaction.

    9.

    A public good is a good or service that is not excludable and is not rivalrous. Common ownership means
    anyone can have access to the item commonly owned.
    As a result, no one has an incentive to pay for it or to
    take care of it.
    10. Asymmetric information means that buyers and sellers have different amounts of information about a private transaction. This can lead to adverse selection
    where bad quality drives low quality out of the market. It can also lead to moral hazard where people
    change their behavior after an agreement to behave in
    a certain way has been made.
    ?

    How might market failures be corrected?

    11. One solution to market failure is to clearly define private property rights.
    12. One solution to market failure is for the government
    to intervene with a tax or a subsidy.
    13. One solution to market failure is for government to
    dictate what behavior is allowed.
    14. One solution to market failure is for government to
    define private property rights, specify quantities, and
    turn allocation over to a market.
    ?

    What are government failures?

    15. Legislators may participate in logrolling in order to
    get benefits for constituents and get elected.
    Logrolling is the practice of trading votes—I vote for
    your bill if you vote for mine.
    16. Government decisions may be determined by special
    interest groups rather than what is best for the economy or society as a whole.

    EXERCISES
    1.

    2.

    Suppose the Disney Company was experiencing
    above-normal profits. What would you predict would
    happen over time?
    The South American cocaine industry consists of
    several “families” that obtain the raw material, refine
    it, and then ship it to the United States. It is not a
    difficult business to enter, particularly on the retail
    end where drug dealers sell the drug to consumers in

    Chapter 7 / Business, Society, and the Government

    3.

    the United States. What would you predict would
    happen to the economic profits of the drug dealer?
    Suppose the families in South America form a cartel.
    What is the result of the cartel?
    Explain why a proposed merger between Staples and
    Office Max was not allowed by the Department of
    Justice.

    149

    4.

    How would you derive the demand for milk at the local grocery store? How would you derive the demand
    for tuna? How would you derive the demand for national defense?
    The government is considering the adoption of a higher
    standard of success in tests for pharmaceuticals that
    will be sold in the United States. Suppose the benefits
    of the regulation were 1,000 lives saved per year.
    Would you support adoption of the regulation? Explain.
    Smokers impose negative externalities on nonsmokers. Suppose the airspace in a restaurant is a resource
    owned by the restaurant owner.
    a. How would the owner respond to the negative externality caused by smokers?

    5.

    6.

    Internet
    Exercise

    150

    7.
    8.
    9.

    b. Suppose smokers own the airspace. How would
    that change matters?
    c. If the government gives ownership of the air to
    nonsmokers, would that change matters?
    d. What does a ban on smoking in the restaurant do?
    Discuss the argument that education should be subsidized because it creates a positive externality.
    Why is national defense called a public good?
    Explain why the number of elephants and rhinos is
    declining in nations where the animals are housed on
    national parks and rising in nations where the animals
    are privately owned and farmed by individuals.

    Use the Internet to familiarize yourself with the FTC and its role in regulating the
    behavior of large firms.
    Go to the Boyes/Melvin Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise link
    for Chapter 7. Now answer the questions that appear on the Boyes/Melvin website.

    Part Two / Consumers, Firms, and Social Issues

    Study Guide for Chapter 7
    Key Term Match

    17. government regulation of health, safety, the
    environment, and employment policies
    18. rivals agree not to complete with each other

    Match each term with its correct definition by placing the appropriate letter next to the corresponding
    number.
    A.
    B.
    C.
    D.
    E.
    F.
    G.
    H.

    collusion
    cartel
    facilitating practices
    cost-plus markup
    pricing
    most-favored customer
    monopolization of
    a market
    antitrust
    regulation

    I.
    J.
    K.
    L.
    M.
    N.
    O.
    P.
    Q.
    R.

    natural monopolies
    externalities
    private property rights
    internalized
    public goods
    free rider
    adverse selection
    moral hazard
    social regulation
    logrolling

    1. actions that lend to cooperation among rivals
    2. a cost or benefits created by a transaction that is
    not paid for or enjoyed by those carrying out the
    transaction.
    3. the control of some aspect of business by
    government
    4. the right to claim ownership of an item
    5. market dominance by one firm that is gained
    unfairly
    6. a situation where what was an external cost is
    paid for by the parties creating the cost
    7. a good that is not excludable and is not rivalrous
    8. rules of behavior prescribed by the government
    to limit monopolization
    9. an organization of independent producers that
    dictates the quantities produced by each member
    of the organization
    10. a price set by adding an amount to the per-unit
    cost of producing and supplying a good or
    service
    11. a commitment that the customer will receive a
    lower price if anyone else receives a lower
    price
    12. a consumer or producer who enjoys a good without paying for it
    13. a situation where a lack of information causes
    low quality items to dominate a market and high
    quality items to be driven out of the market
    14. a situation where imperfect information provides
    an incentive for a consumer or producer to change
    behavior after agreeing to a specific behavior
    15. when economies of scale lead to just one firm
    16. legislators support one another’s projects to ensure support for their own projects

    Chapter 7 / Competition, Cooperation, and the Government

    Quick-Check Quiz
    1

    The result of competition is referred to as
    ■ a. the drive for success.
    ■ b. economies of scale.
    ■ c. creative destruction.
    ■ d. cartels.
    ■ e. monopolization of markets.

    2

    Collusion refers to a situation where
    ■ a. rivals agree to lower price as much as
    possible.
    ■ b. rivals refuse to deal with each other.
    ■ c. rivals agree not to reduce prices.
    ■ d. rivals form an organization to help with advertising.
    ■ e. rivals merge to become one big firm.

    3

    A cartel has the purpose of
    ■ a. increasing the profits of the members.
    ■ b. decreasing the profits of the members.
    ■ c. reducing the number of rivals.
    ■ d. increasing the number of rivals.
    ■ e. ensuring that consumers benefit the greatest
    amount possible.

    4

    Government intervenes in the market for which of the
    following?
    ■ a. to prevent monopolization of a market
    ■ b. to prevent collusion
    ■ c. to prevent price fixing
    ■ d. to reduce issues associated with creative destruction
    ■ e. all of the above are possible reasons government might intervene in markets

    5

    The decision to enter a freeway creates
    ■ a. an externality in that it affects others on the
    freeway.
    ■ b. an internality in that it affects others on the freeway.
    ■ c. a moral hazard in that no one knows why the
    person is on the freeway.
    ■ d. adverse selection because only the worst drivers
    will be on the freeway.
    ■ e. no ill effects.

    151

    6

    When nobody owns something, _____ takes care of it.
    When someone owns something, _____ takes care of
    it. When everyone owns something, _____ takes care
    of it.

    ■ a. nobody; everybody; somebody
    ■ b. nobody; somebody; nobody
    ■ c. nobody; everybody; nobody
    ■ d. somebody; nobody; everybody
    ■ e. somebody; nobody; somebody
    7

    When people can enjoy a good or service without
    paying for the good or service, we say that the good or
    service is

    ■ a. a moral hazard.
    ■ b. a public good.
    ■ c. a free rider.
    ■ d. an adverse selection.
    ■ e. a negative externality.
    8

    The government often intervenes to solve market failure problems. But the government may have failures
    of its own. Which of the following could be described
    as a government failure?

    ■ a. inefficiencies due to incentives of individuals in

    Practice Questions and Problems
    1

    2

    3

    4

    pass smoking bans. We could describe secondhand
    smoke as

    ■ a. a cost of legislation.
    ■ b. a benefit to smokers.
    ■ c. a negative externality.
    ■ d. a public good.
    ■ e. a positive externality.
    152

    The objective of businesses is to

    .

    If rivals decide they can earn more by agreeing not to
    compete, then their agreement is called
    5

    .

    An organization of independent rivals that acts as if it
    was a monopoly would be called a

    6

    7

    .

    The set of laws intended to create a level playing
    field, that is, to prevent the unfair monopolization of a
    market, is called

    .

    A natural monopoly would be a firm operating in a
    business for which
    (economies,
    diseconomies) of scale exist throughout the entire
    market. This would enable a larger firm to be
    (more, less) efficient than a smaller
    firm and thus be able to charge a
    (higher,lower) price than the smaller firm.

    monopoly.

    10 Secondhand smoke has led antismoking crusaders to

    (do,

    don’t) like the results of market allocation.

    ■ a. the monopoly is gained unfairly.
    ■ b. consumers receive benefits from the
    scale.
    ■ d. the monopolist makes political contributions.
    ■ e. the government grants the monopoly.

    People will call on the government to allocate goods
    and services when they

    Monopolization of a market can be illegal when

    ■ c. the monopolist benefits from economies of

    Competition results in inefficient and obsolete goods
    and resources being replaced. This process is called
    .

    government

    9

    getting

    the scarce goods or services and
    not receiving those goods and services.

    ■ b. using votes to allocate goods and services rather
    than markets
    ■ c. adverse selection
    ■ d. moral hazard
    ■ e. natural monopolies

    Market allocation results in

    8

    When the government pays for and provides a good
    or service or dictates the prices and quantities firms
    can charge and must sell, we say that the firms are
    .

    9

    When you drive your car, the fuel is burned and exhaust created. The exhaust is expelled from the engine
    and into the air. The cost of the emission is not paid by
    you—it is instead paid for by innocent bystanders.
    This situation is referred to as a
    .
    If the problem is solved, we say that the cost has been
    .

    Part Two / Consumers, Firms, and Social Issues

    10 One solution to some market failures is to assign

    ownership or
    . When this is
    possible, it allows the affected parties to negotiate a
    solution. This was the idea of what economist?
    11 Chickens and cows are not on the endangered species

    list but the black rhino is. Why?
    12 A market-based solution to an externality problem

    requires that what exists? (Think of the example of
    pollution and pollution permits.)
    13 During the last few decades

    (regulation, social regulation) has been out of favor
    but
    lation) has grown.

    (regulation, social regu-

    14 The government regulates many activities and im-

    poses rules of behavior on many businesses. To determine whether the regulations are worth the costs, it is
    necessary to carry out a comparison of
    and

    .

    15 Suppose that a new law limiting the use of greenhouse

    gases is being considered. It is estimated that the law
    will cost $900 billion per year, or $100 million per life
    saved. What would the value of life have to be for
    this law to make economic sense?

    Exercises and Applications
    Cartel Behavior The key difference between oligopoly
    and other market structures is that oligopolists are interdependent: the decisions of one affect the others. In many
    situations, interdependence creates conflicting incentives
    both to cooperate with others and to “cheat” on one’s
    cooperation.
    You can see how this happens in oligopolies by
    looking at the choices faced by a member of a cartel
    such as OPEC. Let’s make you the oil minister of
    Scheherazade, a hypothetical small member of OPEC.
    You are responsible for managing your country’s oil
    output and price, and your objective is to maximize
    your country’s total revenues from oil. (Your marginal
    cost of producing more oil is so low that you don’t have to
    pay any attention to costs.)
    Last week, the OPEC countries met and agreed to
    charge $25 per barrel for oil. Scheherazade was given an
    output quota of 300,000 barrels per day. The following
    graph shows your current position and possible options.
    D1 is the demand curve for your oil if the rest of OPEC ignores any price changes you make, and D2 is your demand
    curve if the rest of OPEC matches any price changes. As in
    the kinked-demand-curve model, the other members of
    OPEC will ignore any price increases you make but will
    match any price cuts they know about. Use this information to answer the following questions.

    Price per Barrel

    26
    25
    24

    D1

    D2
    250

    298 300 302

    350

    Quantity of Oil Sold (thousands)

    Chapter 7 / Competition, Cooperation, and the Government

    153

    1. At

    $25

    per

    barrel,

    Scheherazade

    takes

    in

    from selling 300,000 barrels.
    2. If you could get the rest of the OPEC members to go
    along with raising their prices to $26 per barrel,
    Scheherazade would take in

    .

    5. Late one night, the buyer for Euro-Oil, a large oil refiner, knocks quietly on your door. She offers to buy
    350,000 barrels of oil a day from Scheherazade if you
    cut the price to $24 and keep the price cut a secret.
    Would this deal be profitable for Scheherazade? Explain your answer.

    3. Unfortunately, the rest of the OPEC members think
    that $25 is the best price and will not go along with a
    higher price. If only Scheherazade raises its price to
    .

    4. Because raising your price individually will not
    increase your revenues, you can try cutting the price
    to $24. If the rest of the OPEC members match
    your price cut, Scheherazade will take in
    .

    154

    ✸✔

    ACE s

    $26, it will take in

    -test
    elf

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    Part Two / Consumers, Firms, and Social Issues

    This page intentionally left blank

    Chapter 8

    ?

    Fundamental
    Questions

    1. What does economic
    analysis have to
    contribute to the
    understanding of
    environmental
    issues?
    2. Does the War on
    Drugs make
    economic sense?
    3. Does discrimination
    make economic
    sense?
    4. Does a minimum
    wage make
    economic sense?
    5. Why are incomes not
    equally distributed?
    6. What does it mean
    to be living in
    poverty?

    renewable resources: resources that can renew
    themselves
    nonrenewable resources:
    resources that cannot replenish themselves

    156

    Social Issues

    W

    hat are the major social issues of the
    day? The environment and the possibility of global warming concern people.
    So do income inequality, poverty, and discrimination. But what can be done to alleviate such problems? To propose solutions or even to understand proposals, it is
    necessary to delve deeply into the causes of the problems. Specifically, it is necessary to understand the incentives people have to harm the environment or to protect
    it, to maintain income inequality and poverty or to fight against them. As you know
    by now, this is exactly what economics is supposed to do—to focus on incentives.
    In this chapter we will discuss some of these social problems and look at some
    ramifications of proposed solutions to them. ■

    Preview

    1. GLOBAL WARMING
    With Al Gore’s documentary movie, An Inconvenient Truth, and a voluminous report from the United Nations called the IPCC study, global warming has moved to
    the forefront of social issues. During 2006–2007, it received more media attention
    than poverty, hunger, the war in Iraq, or the genocide in Darfur. Yet, as much attention as has been paid to global warming, the subject remains a controversial one.
    Scientists have come to agree that global temperatures have risen in the past 20
    years. They are not so secure in the argument that the warming is caused by greenhouse gases and other human activities. Yet, most people think that resources
    should be devoted to reducing the warming problem.
    Whether we accept the argument that man has caused the warming or that
    warming is just part of a natural cycle of the sun, we have to ask what the role of
    market allocation is in the issue of global warming. To examine this issue, we look
    at the use and allocation of natural resources.

    1.a. The Market for Natural Resources
    Natural resources refer to two types of resources—renewable resources and nonrenewable resources. Renewable resources are the trees, plants, and animals that
    can reproduce. Nonrenewable resources are the resources that can be used only
    once and cannot be replaced, like coal, natural gas, and oil.

    Part Two / Consumers, Firms, and Social Issues

    Figure 1
    The Market for
    Nonrenewable Resources

    Sfuture
    Price per Barrel of Oil (dollars)

    Supply curve Spresent represents the quantity that resource owners are willing to
    extract and offer for sale during any particular year. As the
    price rises, more is extracted
    now, leaving less available in
    the future, Spresent to Sfuture.
    The demand for a nonrenewable natural resource depends on what the resource
    contributes to the firm’s revenue and consumers’ enjoyment. Equilibrium occurs in
    the market for a nonrenewable natural resource when
    the demand and supply
    curves intersect.

    Total
    Amount in
    Existence

    Spresent
    20

    15

    Demand
    0

    200

    Quantity of Resource (billions of barrels of oil)
    /time period

    Let’s consider the nonrenewable natural resources first. Only a fixed amount of
    oil or coal exists, so the more that is used in any given year, the less that remains for
    future use. As some of the resource is used today, less is available next year. This is
    shown in Figure 1. The vertical line along the right side of the figure illustrates the
    idea that there is a fixed amount of the resource. Although there is a fixed amount in
    total, at any given time there is a varying amount depending on the price of the resource. For example, supply curve Spresent represents the quantity that resource owners are willing to extract and offer for sale during any particular year. As the price
    rises, more is extracted now, leaving less available in the future. This causes the supply curve of the resource in the future to shift up, as shown in Figure 1 by the move
    from Spresent to Sfuture. The shift occurs because the cost of acquiring or extracting the
    resource rises as the amount of the resource in existence falls. For instance, in the
    late 1800s, oil became an important resource. At first, it was extracted with small
    pumps that gathered up the oil seeping out of the ground. Once that extremely accessible source was gone, wells had to be dug. Over time, wells had to be deeper and
    be placed in progressively more difficult terrain. From land, to the ocean off
    California, to the rugged waters off Alaska, to the wicked North Sea, the search for oil
    has progressed. Each progression is more difficult and thus more costly.
    The demand for a nonrenewable natural resource is determined in the same way
    as the demand for any other resource. Demand is the value of that resource to the
    firm and to consumers at each price—what the resource contributes to the firm’s
    revenue and consumers’ enjoyment.
    Equilibrium occurs in the market for a nonrenewable natural resource when
    the demand for and supply of that resource are equal, as shown in Figure 1 at
    $15 and 200 billion barrels. The equilibrium price, $15, and equilibrium quantity, 200 billion barrels, represent the price and quantity today. Extracting and
    selling the equilibrium quantity of 200 billion barrels today reduces the quantity
    available in the future by 200 billion barrels. This means that extracting the resource tomorrow is probably going to be more costly than extracting it today. Thus,
    the supply curve for the resource in the future Sfuture lies above the supply curve for
    Chapter 8 / Social Issues

    157

    the present Spresent if any of the resource is being consumed today. With a higher
    supply curve and the same demand, the price is higher, $20 rather than $15. Thus,
    the price in the future is likely to be higher than the price today if some of the resource is extracted and sold today.
    The resource owner must decide whether to extract and sell the resource today
    or leave it in the ground for future use. Suppose that by extracting and selling the
    oil that lies below someone’s land today, the landowner can make a profit of $10 per
    barrel after all costs have been paid. With that $10 the owner could buy stocks or
    bonds to put the money into a savings account or use it to acquire education or
    marketable skills. If the owner could earn 10 percent doing one of these alternatives, then, in essence, the owner would realize $11 one year from now from the
    $10 profit obtained today. Should the oil be extracted today? The answer depends
    on how much profit the resource owner expects to earn on the oil one year from
    now, and this depends on what the price of oil and the cost of extraction are one
    year from now. The high price would also induce people to search for alternatives—to invent new technologies that do not use petroleum, for example.
    You can probably understand why economists argue that it is unlikely the world
    will ever run out of nonrenewable resources. As the total amount of oil or any other
    nonrenewable resource in existence is reduced, its price in the future will rise. It
    will continue rising as the supply dwindles until it is so high that no one would extract the oil today, thus saving it for the future.
    Renewable natural resources are different from nonrenewable resources in the
    sense that renewable (nonexhaustible) natural resources can be used repeatedly
    without depleting the amount available for future use. Plants and animals can replenish themselves if there are enough of a species available to do that. The problem is not that there is a fixed quantity but that a resource will be consumed too
    rapidly for it to reproduce. The role of the market for renewable resources is to determine a price at which the quantity of the resource used is just sufficient to enable
    the resource to renew itself at a rate that best satisfies society’s wants. For instance,
    the rate at which trees are harvested depends on comparing the rate at which the
    value of the forests increases over time and the rate that could be earned by razing
    the forests, selling the trees, and placing the money into another activity today. A
    large harvest one year means fewer trees available in the future and a longer time
    for renewal to occur. This would suggest a lower price for the trees today and a
    higher price in the future, which would induce some tree owners to hold off harvesting their trees.
    The markets for nonrenewable and renewable resources operate to ensure that
    current and future wants are satisfied in the least costly manner and that resources
    are used in their highest-valued alternative now and in the future. When a nonrenewable resource is being rapidly depleted, its future price rises so that less of the
    resource is used today. When a renewable resource is being used at a rate that does
    not allow the resource to replenish itself, the future price rises so that less of the resource is used today.

    1.b. Environmental Problems

    ?
    1. What does economic
    analysis have to
    contribute to the
    understanding of
    environmental issues?

    158

    The markets for natural resources can allocate resources to their highest-valued
    uses as long as private property rights are well defined, externalities are not large,
    and public goods are not a major factor. The problem is that these conditions do not
    all occur in the environmental arena.
    Consider an oil tanker that runs aground and dumps crude oil into a pristine
    ocean area teeming with wildlife, or a public beach where people litter, or even
    your classrooms where people leave their cups, used papers, and food wrappers on
    the floor. A cost is involved in these actions. The crude oil may kill wildlife and
    ruin fishing industries, the garbage may discourage families from using the beach
    and harm wildlife, and the trash in the classroom may distract from the discussions

    Part Two / Consumers, Firms, and Social Issues

    Oil poured from a transport vessel after the vessel ran aground.
    The oil covered nearby beaches,
    caught several species of wildlife
    in its sticky sludge, and led to a
    very expensive cleanup process.

    and lectures. But in none of these cases is the cost of the action borne solely by the
    individuals who took the action. Instead, the cost is also borne by those who were
    not participants in the activity. The fishermen, the fish, and other wildlife did not
    spill the oil, yet they have to bear the cost. The beach-goers who encounter trash
    and broken bottles were not the litterers, yet they must bear the cost of the litter.
    You do not create the garbage and yet must wade through the trash. The cost is external to the activity that created it and is thus called an externality, in this case, a
    negative externality. The total cost of a transaction or activity includes the external
    costs and the private costs. The total cost is called the social cost.
    Similarly, consider a gas station selling gasoline with pumps that have no emission control equipment. Each time a consumer pumps gas, a certain quantity of pollutants is released into the air. The consumer demands gasoline at various prices as
    reflected by the demand curve. The gas station prices the gasoline in order to maximize profit—setting prices as given by the demand curve at the quantity at which
    marginal revenue and marginal cost are equal, as illustrated in Figure 2.
    The actual costs of the gasoline to society—including the marginal costs and the
    cost of the externality—are given by the marginal-social-cost curve, MSC. The
    price ought to be PMSC rather than PMC and the quantity purchased ought to be QMSC
    rather than QMC if all costs are to be accounted for. According to society’s desires,
    “too much” gasoline is purchased.
    In contrast to negative externalities, private costs exceed social costs when
    external benefits are created. In the case of a positive externality, the MSC curve
    would lie below the MC curve and “too little” of the good or service would be
    produced and purchased. From society’s viewpoint, too few people are vaccinated
    against communicable diseases when individuals have to pay all the costs of
    inoculations.
    Market problems may also result because of the absence of well-defined private property rights. A private property right is the right to claim ownership of an
    item. It is well defined if there is a clear owner and if the right is recognized and
    enforced by society. The lack of private property ownership or rights is common
    in the natural resources area. No one has a private property right to the ocean or
    air. No one owns the fish in the sea, no one owns the elephants that roam the
    African plains, no one owns the rain forest, and no one owned the American buffalo or bald eagle. Because no one owns these natural resources, the natural
    resource market cannot function to ensure that the correct or optimal amount of
    the resource is used.

    Chapter 8 / Social Issues

    159

    Figure 2

    MSC

    Externalities

    MC (private)

    PMSC
    Price of Oil

    A firm selling a product
    whose consumption generates a social cost would sell
    the amount given by
    MR = MC, ignoring the social
    costs. Society would prefer
    the price and quantity given
    by MR = MSC in order to take
    into account the social cost.

    PMC

    D
    MR
    QMSC QMC
    Quantity of Oil/Time Period

    Now You Try It
    Explain why tigers are on the
    endangered species list and
    chickens are not.

    The resource markets would solve the problem of harvesting now or in the future if someone owned the forests, oceans, and animals. Without private ownership,
    however, no one has the incentive to sell the resources at the profit-maximizing
    rate. A fishing crew has no incentive to harvest the “right” amount of fish since
    leaving fish until the future simply leaves them for other fishing crews today. If
    someone owned the fish, that resource owner would sell the fish only up to the
    point that the value of fish caught in the future would equal the future value of the
    revenue obtained from the fish caught today.
    1.b.1. Greenhouse Gases Many chemical compounds found in the Earth’s
    atmosphere act as “greenhouse gases.” These gases allow sunlight to enter the

    The Botswana, Zimbabwe, and
    South African governments allow
    individuals to own elephants.
    These elephant “farmers” ensure
    that the elephants breed and
    reproduce so they can be sold
    for their tusks, for hunting in
    special hunting parks, or to
    zoos in developed nations. This
    policy has led to a revival of
    the elephant population in the
    nations allowing private ownership. Most other nations have
    created national parks in which
    hunting is forbidden, but these
    parks have not stemmed the
    tide of extinction of the species.

    160

    Part Two / Consumers, Firms, and Social Issues

    atmosphere freely, and when sunlight strikes the Earth’s surface, some of it is
    reflected back toward space as heat. The greenhouse gases absorb and then trap the
    heat in the atmosphere. Some of these greenhouse gases occur in nature (water
    vapor, carbon dioxide, methane, and nitrous oxide) and some are man-made. A
    problem arises from the gases only if emissions and absorption are not in balance.
    Global warming is the result of an imbalance of emissions and absorption, that is,
    when too many greenhouse gases accumulate in the atmosphere.
    The existence of externalities and ill-defined or nonexistent private property
    rights have led to the accumulation of greenhouse gases. In Figure 3, the market for
    products that create greenhouse gases is illustrated. We will use the market for
    aerosols. The demand and supply determine the quantity bought and sold, Q*,
    which creates a level of emissions E*. The cost of the emissions is not part of the
    cost of selling and buying the aerosol products. If it were, supply would shift in so
    that the quantity of aerosol bought and sold would decline to Q and the level of
    emissions would be less, E rather than E*.

    1.c. Solving Global Warming
    If we accept global warming as fact and we accept the argument that it is caused by
    greenhouse gases as fact, then the question becomes how to reduce greenhouse
    gases. If the problem is the result of market failures, then solutions must involve
    dealing with these market problems. In Figure 3, the level of emissions desired by
    society is E; that is, the level determined by demand and supply when all external
    costs have been internalized. To get to E, the supply of aerosols must decline, and
    this occurs when producers must pay for the costs of the emissions. When all costs
    are internalized, the quantity is Q (E < E*).
    The theory as illustrated in Figure 3 is relatively straightforward. But, in reality
    things are more complicated because the entire globe is involved. It is difficult to
    assign ownership over emissions when the emissions go across national borders.
    Emissions created in the United States float into Canada; emissions from China
    coast into neighbouring nations and across oceans. These national issues are discussed and debated annually by the United Nations. In 2002 the discussions resulted in the Kyoto Protocol, which assigned responsibility for greenhouse gases to
    the developed nations and gave each a target for reducing emissions.

    Figure 3
    Market for Products That
    Create Greenhouse
    Emissions
    The demand and supply
    for aerosol show that the
    market-determined quantity
    is Q*. Q* creates greenhouse
    emissions of E*. If the externalities are internalized, the
    supply curve shifts in and
    output of aerosol is reduced.
    The level of emissions is
    reduced to E from E*.

    $

    Supply after paying
    for externalities
    Supply

    Demand
    Q (E < E*) Q* (E*)
    Quantity of Aerosol

    Chapter 8 / Social Issues

    161

    Unfortunately the reduction of greenhouse gases is not a free good. There are
    tradeoffs; reducing some emissions means changing some types of purchases and
    behaviors. Figure 3 illustrates how aerosols have to be reduced. But, reducing
    aerosols is just the beginning. Reducing more emissions means forgoing the burning of fossil fuels, such as coal, and relying on far more expensive energy sources.
    In Figure 4 the marginal costs and marginal benefits of reducing global warming
    are illustrated. The cost of reducing one more unit of greenhouse gas is the MC and
    the benefit of reducing one more unit of greenhouse gas is the MB. The marginal
    cost rises exponentially, indicating that the first units of reduction have small costs.
    Changing how efficiently automobiles burn fuel would not be tremendously costly.
    Similarly, restricting the use of aerosols is not too costly. But, after fairly easy steps
    are taken, then it becomes necessary to take some fairly drastic and costly actions.
    The amount of energy used by each person would have to be severely limited.
    Some mining, manufacturing, and production would have to be eliminated. Inhalers used by asthmatics would not be able to use the gas that propels the medicine into the lungs, so the cost of inhalers would rise. In other words, the more
    greenhouse gases eliminated, the greater the marginal cost of eliminating even
    more. The marginal benefits, on the other hand, decline as greenhouse gases are reduced. The first reductions in emissions might provide benefits by reducing pollutants and cleaning the air and water. But continued reductions would mean fewer
    and fewer additional benefits.
    The economically optimal reduction would occur where MC = MB or quantity
    Q*. The important lesson, illustrated in Figures 3 and 4, is that there are tradeoffs—reducing global warming is not free. The more greenhouse gases eliminated,
    the greater the cost.
    Have scientists come up with any real numbers to go along with the theory?
    Yes, in fact there is a wide range of numbers. According to results presented by
    the United Nations and the U.S. Department of Energy, the worldwide cost of
    implementing the Kyoto Protocol is about $350 billion per year beginning in 2010,
    and the cost will rise to $900 billion a year by 2050. The cost to the United States
    alone would be about $300 billion per year. U.S. real gross domestic product
    (RGDP is a measure of the nation’s total income) is about $1.2 trillion, so implementing the Kyoto Protocol would mean a reduction of national income of about
    25 percent, $300 billion/$1,200 billion. So the cost of implementing the Kyoto

    Figure 4

    The incremental costs get
    larger and larger and additional greenhouse emissions
    are reduced. The incremental
    benefits get smaller and
    smaller. The economically
    optimal level occurs where
    MC = MB, Q*.

    MC
    Costs and Benefits

    Marginal Costs and
    Marginal Benefits of
    Reducing Greenhouse
    Emissions

    MB

    Q*

    90%

    Quantity of Global Warming Reductions

    162

    Part Two / Consumers, Firms, and Social Issues

    targets would be very large; it would mean a reduction in standards of living of
    about 25 percent.
    Would spending $300 billion a year on implementing the emission targets be
    worth it? What are the benefits of reducing emissions? According to worst-case
    scenarios, the serious effects of global warming will not occur until about 100
    years from now. These scenarios indicate that by 2100, the cost could be as much
    as $900 billion. So, society can choose to pay some $300 billion a year for about
    100 years to reduce the costs of warming or it can choose to wait for 50, 75, or 100
    years before devoting significant resources to the issue. Will society wish to reduce
    incomes now to improve wealth for future generations?

    R E C A P

    1. Nonrenewable natural resources are natural resources whose supply is fixed.
    Renewable natural resources are natural resources that can be replenished.
    2. The gap between the equilibrium price today and the equilibrium price at
    some point in the future generates a rate of return on resources. When that rate
    of return exceeds what is currently available elsewhere, then the resource is
    not extracted or used. When that return is less than what can be earned elsewhere, the resource is extracted and sold.
    3. Under ideal economic conditions, the harvest rate of renewable resources is
    such that the amount used meets society’s demands and allows the resources
    to reproduce.
    4. Environmental problems may arise either because of an externality or because of the lack of private property rights.
    5. Global warming occurs because the emissions of greenhouse gases trap heat
    in the atmosphere.
    6. Greenhouse gases are emitted naturally and from man-made activities.
    7. The emissions are excessive due to lack of private property rights and externalities. Assigning ownership and internalizing externalities will ensure that
    the levels of emissions are the levels society is willing and able to pay for.
    8. The United Nations assigned the developed nations targets for reducing
    emissions in what is known as the Kyoto Protocol.
    9. There is a cost to reducing emissions. The cost is what must be given up, the
    opportunity cost. There is a benefit to reducing emissions. The optimal
    amount of reduction of emissions occurs where the marginal costs and marginal benefits are equal.

    2. ILLICIT DRUGS
    The market for illicit or illegal drugs is complicated, large, and a very interesting
    illustration of how markets function. Worldwide trade in illicit drugs constitutes 4
    percent of total world trade, as much as textiles and steel. The biggest share of the
    trade occurs in the United States. Americans spend nearly $60 billion a year on illegal drugs—$38 billion on cocaine, $10 billion on heroin, $7 billion on marijuana,
    and $3 billion on other illegal drugs—about 60 percent of all illicit drugs consumed
    in the world.

    2.a. The Suppliers
    Figure 5 illustrates the demand, cost, and profit conditions of a supplier of illicit
    drugs. The supplier’s costs include harvesting and refining the drug, transporting it
    Chapter 8 / Social Issues

    163

    Figure 5
    The Market for Illicit Drugs

    ATC
    Price of Drugs

    The market demand consists
    of the demand of all users,
    addicts as well as casual
    users. The supplier of the
    drugs finds the quantity, Q,
    at which MR = MC and sets
    price at the demand for the
    quantity, P.

    P
    MC

    MR

    D

    Q
    Quantity of Drugs/year

    to the drug dealers in the United States, paying employees, and securing the
    weapons and bribes necessary to carry out the business. Those costs are shown as
    the average total cost and marginal cost curves. The supplier will maximize profit
    by determining the quantity at which MR = MC and then setting price to sell that
    amount. The resulting quantity is Q and the price is P.
    The supplier is earning a positive economic profit, so other suppliers want to get
    in on the business. The ease or difficulty of entry depends on the type of illicit
    drugs. It is not difficult to enter the market for the so-called designer drugs like amphetamines and crystal ice. A few over-the-counter chemicals and an abandoned
    building are sufficient to manufacture the drugs. The markets for cocaine and
    heroin are more difficult to enter. A supplier must have access to the resources
    (coca and poppies) as well as the refining facilities and transportation and distribution channels to get the product to the market.
    Since there are few suppliers in the cocaine and heroin markets, what each one
    does affects the others. If one attempts to increase its market area, the others respond. If one lowers the price, the others respond. In situations in which there are
    just a few suppliers, the suppliers often decide it is better to cooperate than engage
    in cutthroat competition. Thus, drug cartels have been formed, such as Medellin,
    Sinaloa, Belarussa, and so forth. The cartels assign members territories and dictate
    quantities and prices.
    As with most cartels, there is an enforcer, ensuring that other members follow
    the rules. In the Organization of Petroleum Exporting Countries (OPEC), Saudi
    Arabia serves as the enforcer. Whenever one of the member nations decides to increase oil production above its quota, Saudi Arabia will open its facilities and
    flood the market with oil. The cheating nation ends up with lower revenues than
    if it had remained within its quota. In the National College Athletic Association
    (NCAA), whenever a school athletic department cheats, the NCAA administration penalizes it with forfeiture of prize money and sanctions.
    The enforcer in the drug cartel literally destroys the errant supplier; drive-by
    shootings, bombings, and so on, are the ways in which the cartel’s enforcer ensures
    that cheating by members of the cartel won’t occur.
    As with all profit-maximizing firms, drug suppliers want to alter the demand
    curves for their products, making them more price-inelastic and shifting them out.
    Since the demand by the hard-core user is very price-inelastic already, the suppliers focus on the experimenter’s demand. By offering discounts, higher-quality

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    Part Two / Consumers, Firms, and Social Issues

    drugs, and even free samples, the suppliers hope to change the price elasticity of
    demand.
    The suppliers would also like to reduce their costs. The primary cost of the drug
    suppliers is the cost of avoiding having products confiscated, employees arrested,
    and facilities destroyed. Suppliers attempt to reduce the probability of such costs
    by bribing or, in some cases, assassinating officials.
    Although operating in an illegal market means there are costs of avoiding detection, would the existing suppliers like to see drugs legalized? The answer is a
    resounding NO. Legalization would reduce the costs of entry to potential new suppliers and drive down economic profits.

    2.b. The War on Drugs

    ?
    2. Does the War on Drugs
    make economic sense?

    Now You Try It
    Using Figure 5, illustrate a
    case where demand is perfectly
    elastic. Show how price will
    not rise when costs rise.

    Chapter 8 / Social Issues

    Throughout the ages, governments have chosen to ban many things. In Egypt in the
    1500s, coffee was banned. Tobacco was banned in Russia and the Ottoman Empire
    in the 1700s. The United States has banned the sale and use of alcohol and illicit
    drugs. In 1920, alcohol was prohibited, but was made legal again in 1934. Opiates
    and cocaine were banned in the United States in 1914; marijuana was banned in
    1937 and remains prohibited today. Although bans on chemicals such as DDT or
    trans fats or on smoking in specific locations seem to have required few resources
    to enforce, the United States has devoted enormous resources to attempting to control the market for illicit drugs, without much apparent success. The federal government currently spends about $30 billion per year on what is called the War on
    Drugs. State and local governments spend another $20 billion each year. In addition, nearly 50 percent of all arrests and incarcerations are related to the drug war.
    Yet, consumption of drugs has increased over the past 20 years.
    The government’s War on Drugs focuses primarily on the supply side of the
    market. Most economists agree that the War on Drugs has raised the cost of supplying and selling drugs. Some costs are not increased—drug suppliers, for example,
    do not pay income taxes or Social Security taxes, nor do they obey minimum wage
    laws or other labor regulations. Nevertheless, the net effect of prohibition is to increase the costs of supplying the good or service. Who pays these higher costs? Because the buyer wants the drugs almost as much at a very high price as at a low
    price, the supplier just adds the extra costs to the price. In other words, the costs are
    passed on from supplier to buyer. The supplier can do this because demand is inelastic, meaning that drug users are not very sensitive to price increases. The more
    inelastic the demand, the more the increased costs will be passed along from the
    supplier to the consumer in terms of a higher price. It is the consumer who pays the
    higher costs rather than the supplier. In Figure 6 the extreme case of a perfectly inelastic demand is illustrated. The MC curve shifts up to reflect the increased costs
    imposed on the suppliers. But, the supplier simply increases the price, from P1 to
    P2. The price increase fully reflects the increased costs.
    The more elastic the demand, the less can be passed along to consumers in terms
    of a higher price. If, for example, demand was perfectly elastic, then none of the
    increased costs could be passed along to consumers as a higher price.
    Why is it so difficult to eliminate a good or service? It is because of the price
    elasticity of demand. When demand is inelastic, prohibition means driving up
    prices but not reducing the quantity demanded. Banning something with an elastic
    demand would be much easier. In fact, if demand was very elastic, a ban could
    drive the product out of existence. Raising the suppliers’ costs results in a reduction
    in profits since suppliers cannot raise price and continue selling about the same
    amount. Buyers are not willing and able to pay a higher price for the banned item.
    So if economic profit is driven down to where it is negative, suppliers would stop
    supplying.
    The ban on illicit drugs leads to a higher price. This means that drug users
    have to look for a way of getting the same result at a lower cost. During alcohol

    165

    Figure 6

    Price

    A Perfectly Inelastic
    Demand and the War
    on Drugs
    The supplier can pass along
    costs to the consumer in
    terms of a higher price. In the
    case of a perfectly inelastic
    demand, the price increase is
    equal to the increased costs
    caused by the War on Drugs.

    MC 2
    MC

    P2
    P1
    D
    Quantity of Drug

    prohibition (1920–1933), the United States changed from consuming mostly beer
    and wine to consuming primarily bourbon and gin. Consumers wanted to consume alcohol, but the illegality of it drove prices up. The higher prices caused
    consumers to look for forms of alcohol that were less costly. Since bourbon and
    gin had about 40 percent alcohol and beer and wine less than 10 percent, bourbon
    and gin were better buys. In addition, the supply of beer and wine was reduced
    more than that of so-called hard liquor. Suppliers found it more profitable to deal
    in the most potent form of liquor possible. Why risk smuggling a keg of beer
    when a case of whiskey brought higher profits at a lower risk of being found out
    by authorities? The same thing has occurred with illicit drugs. In a drug-producing countries like Peru and Afghanistan, people use illicit drug crops in their
    natural form (chewing coca leaves and smoking raw opium), which is far less
    powerful than the processed forms in which the drugs are available in the Western
    countries.
    Suppliers begin supplying ever more potent forms of the banned substance because their profit per unit of output is higher. In addition, because purchases of the
    banned substance are illegal, buyers have no way to verify the quality of the product they are buying. When you purchase aspirin, you know the brand name of the
    supplier—Bayer, for instance. Cocaine users don’t know whether the fellow on the
    street corner is reliable or even if he will be there tomorrow. As a result, the
    supplier may “cut” his drugs with impurities or substances that increase profit.
    These may lead to bad reactions or even death. In fact, many so-called overdoses
    appear to be negative reactions to impurities in the drugs.
    Illicit drugs are typically supplied by a monopoly or a cartel acting like a monopoly. Each drug dealer is a member of the cartel. As such, they are told how
    much they can sell, where they can sell it, and the price they must charge.
    Although drug dealers might be making money by selling their prescribed drugs at
    prescribed prices, each also thinks that he or she could do better selling even more
    or selling at a higher price. So, quite often, the drug dealers try to push a few more
    drugs, move to a better location, or charge a slightly higher price. These practices
    create problems for the cartel. If one drug dealer gets away with the behavior, others may try to do the same thing. If the practices become widespread, the cartel
    would dissolve, and economic profits would be driven down as competition and

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    Part Two / Consumers, Firms, and Social Issues

    entry occur. So the cartel ensures that members don’t cheat. Gang killings and turf
    battles are typically the cartel’s enforcers making sure that the dealers don’t cheat
    on the cartel.
    Some consumers are unable to pay the higher prices for the drugs. But, desiring
    the drugs or being addicted to them means the consumers must obtain money. One
    way to do this is through crime. As prohibition occurs and becomes more stringent,
    crimes of property and theft rise.

    2.c. Alternative Drug Policies
    Nobel economist Milton Friedman argued as long ago as 1972 that legalizing drugs
    would simultaneously reduce the amount of crime and raise the quality of law enforcement. Yet the idea never gathered much support, probably because of the fear
    that legalization would lower prices and cause more people to try the drugs. For instance, it’s estimated that cocaine sells for 10 to 40 times its free market price, so
    the drug would be much less expensive if legalized.
    What does the lower price do to consumption? It depends on the price
    elasticity of demand. Although demand for illicit drugs is highly inelastic, it is not
    perfectly inelastic. This means that lower prices for drugs would encourage some
    additional consumption. How much more would depend on how inelastic demand
    is. So if it is feared that legalizing drugs will lead to more drug use, then legalization would require some policy to stem drug use. Some economists have argued
    that the way to offset the effects of legalized drugs on drug consumption is to
    impose a high tax. The tax would mean that drug prices do not really decrease
    after they are legalized. A high tax might lead to some smuggling and illegal activity to avoid the tax, but the profit potential of supplying the cocaine at a price that
    would avoid some of the tax would be much less than exists with the illegal market.
    Moreover, the tax revenue would flow to the government rather than to the drug
    cartels.

    R E C A P

    1. The market for some illicit drugs is difficult to enter. Suppliers have formed
    cartels and restricted entry.
    2. The demand for illicit drugs is inelastic.
    3. Increasing the costs of supplying drugs causes the suppliers to increase the
    price. Because demand is inelastic, the suppliers’ profits remain high and
    drug users pay the increased costs in terms of a higher price.
    4. Prohibition has increased costs, led to more potent forms of drugs in use, and
    caused increased levels of crime.
    5. Legalization of drugs would lead to lower costs and reduce the ill effects of
    illegal markets. Coupled with a tax, the level of consumption following legalization would not increase.
    6. The market for illegal drugs is easy to enter. As a result, economic profit is
    driven to zero by competition. Drug prohibition can make entry more difficult and enable suppliers to earn positive economic profits.

    3. DISCRIMINATION
    We’ve talked about price discrimination many times in this book. Price discrimination is the practice of charging different customers different prices for an identical

    Chapter 8 / Social Issues

    167

    Figure 7

    MCP

    The demand by customers for
    the product is D. The supplier
    has a marginal cost of MCP
    to supply the good if the employee is a member of the
    preferred group and MCA if
    the employee is not a member of the preferred group.

    Price of Goods and Services

    Discrimination

    MCA

    PP
    PA

    MR
    QP

    D

    QA

    Quantity of Goods and Services/time period

    discrimination: the practice
    of treating people differently
    in a market, based on a
    characteristic having nothing
    to do with that market

    item. Price discrimination occurs because the different customers have different price
    elasticities of demand. Discrimination, in general, is somewhat different from
    price discrimination. Discrimination is the practice of treating different people
    differently in a market, based on some characteristic that has nothing to do with the
    market. In the labor market, discrimination occurs when someone or some group is
    receiving favorable treatment for a reason having nothing to do with that person’s
    or group’s job performance.

    3.a. The Market

    ?
    3. Does discrimination
    make economic sense?

    168

    Discrimination on the basis of characteristics that have nothing to do with one’s job
    performance is costly in a market in which entry is easy. Suppose, for instance, that
    customers preferred to be served by only a certain kind of individual. Customers
    would then have to be willing to pay higher prices to be served by the preferred
    group. This is illustrated in Figure 7.
    The firm can supply the good using the services of any employee, along cost
    curve MCA. The firm can also use the preferred employees, but then the cost of supplying the good is higher, MCP. Those customers who want the product but only if
    served by the preferred group have to pay PP, whereas those customers choosing to
    be served by anyone have to pay only PA.
    Discrimination requires paying a premium to associate or not to associate with
    certain groups. As we know from prior chapters, any firm not using resources efficiently will be driven out of the market if entry is easy. When entry is easy, having
    higher costs due to discrimination could drive the discriminating firm out of the
    market. If customers are not willing to pay the premium (the difference between PP
    and PA), then the firm cannot discriminate.
    If a firm has erected strict barriers to entry, then the discrimination may not
    be costly. A monopoly or even a government agency that does not have to compete with another firm could get away with using resources less efficiently.
    Managers, employees, and even customers of monopolies or government agencies may be able to discriminate without having more efficient firms drive them
    out of the market. Indeed, studies have shown that most discrimination takes
    place in government agencies, firms that do business with the government, and
    regulated monopolies.
    Part Two / Consumers, Firms, and Social Issues

    3.b. Statistical Discrimination

    statistically discriminating:
    using characteristics that apply
    to a group, although not to all
    individual members of that
    group, as an allocation device

    R E C A P

    Discrimination may occur because of a lack of information rather than a taste
    for or against certain groups. For instance, employers must try to predict the
    potential value of job applicants to the firm, but rarely do they know what a
    worker’s actual value will be. Often, the only information available when they
    hire someone is information that may be imperfectly related to value in general
    and may not apply to a particular person at all. Using characteristics like education, experience, age, and test scores as the basis for selecting among job applicants may keep some very good people from getting a job and may result in
    hiring some unproductive people.
    Suppose two types of workers apply for a word-processing job: those who can
    process 80 words per minute and those who can process only 40 words per minute.
    The problem is that these actual productivities are unknown to the employer. The
    employer can observe only the results of a five-minute word-processing test given
    to all applicants. How can the employer decide who is lucky or unlucky on the test
    and who can actually process 80 words per minute? Suppose the employer discovers that applicants from a particular vocational college, the AAA School, are taught
    to perform well on preemployment tests, but their average overall performance as
    employees is less than that of the rest of the applicants—some do well and some do
    not. The employer might decide to reject all applicants from AAA because the
    good and bad ones can’t be differentiated. Is the employer discriminating against
    AAA? The answer is yes. The employer is statistically discriminating. Statistical
    discrimination can cause a systematic preference for one group over another at the
    expense of some individuals in the group.
    What is the effect of a ban on statistical discrimination? It would raise the firm’s
    costs. The firm would have to either collect information about each applicant or
    risk hiring some of the lower-quality word processors. Since costs rise, profits fall.
    This would induce the firm to reduce its output and to reduce the number of resources used, including labor.
    So would a ban on statistical discrimination be a good law even if it raises costs
    and creates job losses? The answer is determined by comparing the costs and benefits to society of allowing statistical discrimination versus the costs and benefits to
    society of outlawing statistical discrimination.

    1. Discrimination is costly in a market economy when entry into markets is easy.
    2. Statistical discrimination occurs due to a lack of information. When the characteristics of a group are imposed on each member of that group whether
    they apply or not, statistical discrimination occurs.

    Discrimination and Poor Word-Processing Skills

    I

    n 2007, Adrian Zachariasewycz
    filed suit against the law firm
    Morris, Nichols, Arsht & Tunnell, as
    well as the University of Michigan
    Law School. Zachariasewycz claims
    that Morris, Nichols fired him
    unlawfully during his summer
    associateship and that the firing
    both defamed him and violated his

    Chapter 8 / Social Issues

    due process rights. In the claim
    brought against the law school, it
    was alleged that Michigan’s grading
    system discriminated against him
    and other students because of poor
    typing skills. The complaint read:
    “Certain exams taken by [plaintiff]
    that required students to be skilled
    touch-typists in order to produce a

    Economic Insight
    competitive response resulted in
    borderline failing grades by virtue of
    the low volume of prose [plaintiff]
    could type in the time allotted as
    compared with other students.” The
    lawsuit asked for an unspecified
    amount of money damages.

    169

    4. MINIMUM WAGE
    minimum wage: the least
    amount an employee can be
    paid according to government
    mandate

    A minimum wage is a government policy that requires firms to pay wages that
    equal or exceed the specified level. The federal minimum wage in the United States
    as of July 2007 was $5.85, but will rise to $7.25 by summer of 2007. Individual
    states may specify their own minimum wage if the wage exceeds the federal level.
    Figure 8 shows the relationship between the state minimum wage and the federal
    level.
    The arguments in favor of the minimum wage are that a worker must earn at least
    the minimum wage in order to have a decent standard of living. At $5.85 per hour,
    40 hours per week, 50 weeks per year, you would earn $11,700 per year. Currently, the
    government defines the poverty level of income for a family of four to be $20,500.
    Thus, at the U.S. federal minimum wage, a family of four with a single wage earner
    would be below the poverty level. The arguments opposed to minimum wages claim
    that implementation of such minimums will increase unemployment, particularly

    Figure 8

    RI
    DE
    MD
    DC

    GU

    AS
    HI

    AK

    PR

    States with minimum wage rates
    higher than the federal

    States with no minimum wage
    law

    States with minimum wage rates
    the same as the federal

    States with minimum wage rates
    lower than the federal

    VI

    Source: U.S. Department of Labor; http://www.dol.gov/esa/minwage/america.htm.

    170

    Part Two / Consumers, Firms, and Social Issues

    ?
    4. Does a minimum wage
    make economic sense?

    Now You Try It
    Using Figure 9, indicate what
    would happen if the minimum
    wage was increased to $8 per
    hour. Then indicate what would
    happen if the minimum wage
    was lowered to $3 per hour.

    R E C A P

    ?
    5. Why are incomes not
    equally distributed?

    among the unskilled—teenagers, minorities, and women—and lead to worse cases
    of poverty.
    In a competitive labor market, a worker’s wage is equal to the value he or she
    contributes to the firm. A minimum wage set above the equilibrium wage creates a
    labor surplus (unemployment). In Figure 9, setting the minimum wage (WM) at
    $5.85, above the equilibrium wage (W) of $4, creates a labor surplus of QS  QD.
    In other words, all the people willing and able to work at $5.85 are unable to get
    jobs. At the $5.85 per hour wage, QS are willing and able to work, but only QD are
    able to find jobs. A surplus of QS  QD workers is created. Notice also that employment falls from the equilibrium level of Qe to QD.
    Who is most affected by the surplus? It is those who have the least value to the
    firm. Studies show that the minimum wage adversely affects teenagers and other
    low-skilled workers, causing increased unemployment in these groups. A 10 percent
    increase in the minimum wage is estimated to result in a 1 to 3 percent decrease in
    teenage employment. The increase in the minimum wage from $4.35 to $5.15 per
    hour was an 18 percent increase. This caused somewhere between a 1.8 to 5.4 percent reduction in teenage employment. To reduce the adverse effects on teens, the
    government has allowed firms to pay a wage to teens that is lower than the minimum
    wage. The lower wage reduces the negative effects on teenagers. Still, any time an
    above-equilibrium or minimum wage is imposed, some job loss occurs.

    1. A minimum wage is a government policy requiring firms to pay at least that
    wage—a wage that is above the equilibrium wage.
    2. The effect of a minimum wage is to reduce employment.
    3. A minimum wage has the greatest negative effects on the unskilled—usually
    teenagers, minorities, and women.

    5. INCOME INEQUALITY AND POVERTY
    In a market system, incomes are distributed according to the ownership of resources. Those who own the most highly valued resources have the highest

    Figure 9
    Surplus

    The imposition of a minimum
    wage reduces the number of
    jobs offered to workers and
    reduces the employment of
    workers.

    Wage Rate per Hour (dollars)

    Minimum Wage

    Supply

    WM = 5.85

    Minimum Wage

    W=4

    Reduction in
    Employment

    Demand
    QD

    Qe

    QS

    Quantity of Workers/Time Period

    Chapter 8 / Social Issues

    171

    income distribution: the ways
    in which a society’s income is
    divided
    Lorenz curve: a diagram
    illustrating the degree of
    income inequality

    incomes. One consequence of a market system, therefore, is that incomes are distributed unequally. In the United States, as in every country, there are rich and there
    are poor.
    The inequality of income distribution among members of a population can be
    illustrated as a graph, as shown in Figure 10. The horizontal axis measures the total
    population in cumulative percentages; as we move along the horizontal axis, we
    are counting a larger and larger percentage of the population. The numbers end
    at 100, which designates 100 percent of the population. The vertical axis measures
    total income in cumulative percentages. As we move up the vertical axis, the
    percentage of total income being counted rises to 100 percent. The 45-degree line
    splitting the distance between the axes is called the line of income equality. At each
    point on the line, the percentage of total population and the percentage of total income are equal. The line of income equality indicates that 10 percent of the population earns 10 percent of the income, 20 percent of the population earns 20 percent
    of the income, and so on, until we see that 90 percent of the population earns
    90 percent of the income, and 100 percent of the population earns 100 percent of
    the income.
    Points off the line of income equality indicate an income distribution that is unequal. Figure 10 shows the line of income equality and a curve that bows down below the income-equality line. The bowed curve is called a Lorenz curve. The
    Lorenz curve in Figure 10 is for the United States. In the United States, 20 percent
    of the population receives only 3.6 percent of total income, seen at point A. The
    second 20 percent accounts for another 9.6 percent of income, shown as point
    B, so the bottom 40 percent of the population has 13.2 percent of the income (3.6
    percent owned by the first 20 percent of the population plus the additional 9.6 percent owned by the second 20 percent). The third 20 percent accounts for another
    15.7 percent of income, so point C is plotted at a population of 60 percent and an
    income of 28.9 percent. The fourth 20 percent accounts for another 23.4 percent of
    income, shown as point D, where 80 percent of the population receives 52.3 percent of the income. The richest 20 percent accounts for the remaining 47.7 percent
    of income, shown as point E. With the last 20 percent of the population and the last
    47.7 percent of income, 100 percent of population and 100 percent of income are
    accounted for. Point E, therefore, is plotted where both income and population are
    100 percent.

    Figure 10
    Total Income (cumulative percentage)

    The Lorenz Curve
    The Lorenz curve illustrates
    the degree of income inequality. The further the curve
    bows down, away from the
    line of equality, the greater
    the amount of inequality.

    E

    100
    90
    80
    70

    Line of
    Income Equality

    60

    D

    50
    40

    Lorenz Curve
    C for United States

    30
    20

    B

    10

    A
    0

    10

    20

    30

    40

    50

    60

    70

    80

    90 100

    Total Population (cumulative percentage)

    172

    Part Two / Consumers, Firms, and Social Issues

    Now You Try It
    With the following data, construct a Lorenz curve.
    Top 20%

    40

    Next 20%

    30

    Next 20%

    20

    Next 20%

    8

    Lowest 20%

    2

    The farther the Lorenz curve bows down, away from the line of income equality,
    the greater the inequality of the distribution of income. From 1929 to 1995, the
    Lorenz curve for the United States moved closer to the line of income equality as
    incomes became more equally distributed. But since 1995, the curve has moved
    farther away from the line of income equality, and the distribution of income has
    become less equal.
    Many people argue that the increasing inequality of income in recent years is the
    result of the increased demand for skilled labor. With skills, people are earning
    relatively more; without skills, they are earning relatively less. Professional, technical, and managerial jobs accounted for just one-sixth of the work force in 1950. By
    2003, that number had risen to more than one-third. This increased demand for
    skilled labor has placed a much higher premium on educational attainment; generally speaking, workers who have spent more time in training and education earn
    significantly higher wages. Between 1984 and 2003, employees with post–high
    school education and training gained more than 11 percent in income while high
    school dropouts’ earnings fell more than 1.5 percent.
    The most unequal distributions of income are found in developing countries. On
    average, the richest 20 percent of the population receives more than 50 percent of
    income, and the poorest 20 percent receives less than 4 percent. Figure 11 shows
    two Lorenz curves: one for the United States and one for Mexico. The curve for
    Mexico bows down far below the curve for the United States, indicating the greater
    inequality in Mexico.

    5.a. Poverty
    poverty: an arbitrary level of
    income chosen to provide a
    measure of how well basic
    human needs are being met

    Unequal income means some people are relatively well-off and some are relatively
    poor. The poorest in the United States are those in poverty. Poverty is an arbitrary
    level of income that is supposed to provide a measure of how well basic human
    needs are being met. The poverty level in the United States, as specified by the federal government, is listed in Table 1. Currently, a family of four with an income less
    than $20,500 in the United States is considered to be living in poverty. Yet an income of $20,500 per year would be a very high level of income in some countries.
    Ethiopia, for instance, has a per capita income of only $150 per year.

    Figure 11

    Income is more unequally
    distributed in Mexico than in
    the United States. This can be
    seen as the Lorenz curve for
    Mexico bows farther away
    from the line of income
    equality than the Lorenz
    curve for the United States.

    100

    Total Income (cumulative percentage)

    The Lorenz Curves for the
    United States and for
    Mexico

    90
    80
    70

    Line of
    Income Equality

    60
    50
    40

    Mexico

    30
    20

    United States

    10
    0

    10

    20

    30

    40

    50

    60

    70

    80

    90 100

    Total Population (cumulative percentage)

    Chapter 8 / Social Issues

    173

    Table 1

    Year

    Average Income Poverty
    Cutoffs for a Nonfarm
    Family of Four in the United
    States, 1959–2006

    1959
    1960

    Poverty Level

    Year

    Poverty Level

    $ 2,973

    1987

    $ 11,611

    $ 3,022

    1988

    $12,090

    1966

    $ 3,317

    1989

    $ 12,675

    1969

    $ 3,743

    1990

    $13,359

    1970

    $ 3,968

    1991

    $13,924

    1975

    $ 5,500

    1992

    $13,950

    1976

    $ 5,815

    1993

    $ 14,764

    1977

    $ 6,191

    1994

    $15,200

    1978

    $ 6,662

    1995

    $15,600

    1979

    $ 7,412

    1996

    $16,036

    1980

    $ 8,414

    1997

    $ 16,276

    1981

    $ 9,287

    1998

    $16,530

    1982

    $ 9,862

    1999

    $16,895

    1983

    $ 10,178

    2000

    $ 17,463

    1984

    $ 10,609

    2001

    $ 17,960

    1985

    $ 10,989

    2002

    $18,244

    1986

    $ 11,203

    2003

    $ 18,811

    2004

    $19,424

    2005

    $ 19,874

    2006

    $20,500

    Source: U.S. Bureau of the Census, Poverty Thresholds, http://www.census.gov/hhes/
    poverty/threshold.html.

    ?
    6. What does it mean to
    be living in poverty?

    How many Americans fall below the poverty line? In 2003, more than 34 million U.S. residents received incomes that were lower than the cutoff. Figure 12
    compares the number of people living in poverty and the percentage of the total
    population living in poverty (the incidence of poverty) for each year from 1960 to
    2005. From 1960 to the late 1970s, the incidence of poverty declined rapidly. From
    the late 1970s until the early 1980s, the incidence of poverty rose; it then began to
    decline again after 1982. Small upswings in the incidence of poverty occurred in
    1968 and 1974, and a large rise occurred between 1978 and 1982. It then fell until
    1990, when the United States once again dipped into recession. It continued to rise
    even as the economy grew in 1993 and 1994 and then fell slightly until 2000, when
    the economy dipped into recession. The greatest impact on poverty is the health of
    the economy.
    Studies indicate that approximately 25 percent of all Americans fall below
    the poverty line at some time in their lives. Many of these spells of poverty are
    relatively short; nearly 45 percent last less than a year. However, more than
    50 percent of those in poverty at a particular time remain in poverty for at least
    10 years.
    Since the young have more trouble finding jobs than the middle-aged, a young
    person has a much greater chance of falling into poverty. The highest incidence of
    poverty occurs among those under 18 years old. The second highest occurs among
    those between 18 and 24.

    5.b. Income Distribution over Time
    We often hear that the rich get richer and the poor get poorer. Is this statement true?
    If we look at the income level of the bottom 20 percent of income earners and

    174

    Part Two / Consumers, Firms, and Social Issues

    Figure 12

    Source: http://www.census.gov/
    hhes/www/poverty.html.

    Number Poor
    (left axis)

    38

    Number of People Who Are Poor (millions)

    The number of people classified as living in poverty is
    measured on the left vertical
    axis. The percentage of the
    population classified as living
    in poverty is measured on the
    right vertical axis. The number
    and the percentage declined
    steadily throughout the
    1960s, rose during the recessions of 1969, 1974, 1981,
    1990, and 2001, and fell
    between 1982 and 1990, and
    again from 1992 to 2000.
    They continued to rise during
    2002 and 2003.

    40

    24
    23

    36

    22
    21

    34

    20

    32

    19
    18

    30

    17

    28

    16
    15

    26

    14

    24

    13

    Percentage
    Poor
    (right axis)

    22

    12
    11

    20

    0

    Percentage of People Who Are Poor

    The Trends of Poverty
    Incidence

    10
    1960

    1965

    1970

    1975

    1980

    1985

    1990

    1995

    2000

    Year

    compare that with the income level of, say, the top 5 percent of income earners, we
    find that between 1980 and 2006, the income level of the bottom 20 percent rose
    13.4 percent while the income of the top 5 percent of income earners rose 46 percent. Clearly, the rich got richer, but the poor also got richer. The difference is in
    the relative increases—the rich had a greater percentage increase in income than
    the poor did. In other words, the distribution of income in 2006 was more unequal
    than it was in 1980.
    Is it income inequality, the number of people living in poverty, or something
    else that is troubling to people? The government has attempted to reduce the number of people living in poverty and the inequality of income for the past 50 years
    through its transfer programs such as social security, welfare, and unemployment
    compensation. Yet, as we have just seen, income is more unequal now than it was
    in 1980.
    While expenditures devoted to reducing poverty have risen several hundred times
    since 1960, the percent of U.S. population living in poverty has remained near 12.5
    percent. Could it be that the measures of poverty are misleading? Perhaps one should
    look at how those defined as poor actually live rather than attempting to measure
    income levels. In one study, it was found that those officially defined as “poor” were
    actually doing much better in 1994 than they had in 1984. In this study, the authors examined what household items these poor households owned. It was found that in
    1984, 70.5 percent of poor households had a color TV; by 1994, 92.5 percent had one.
    In 1984, 3.4 percent had a VCR while 59.7 percent did in 1994. In 1984, 64.5 percent
    of poor families had one or more cars while 71.8 percent did in 1994 (W. Michael Cox
    and Richard Alm, Myths of Rich and Poor [New York: Basic Books, 1999], p. 15). So
    perhaps the definition of poverty (the income levels) needs to be measured differently.
    Doing so might provide a different picture than the one presented in Figure 12.

    Chapter 8 / Social Issues

    175

    Economic Insight

    The Official Poverty Rate

    A

    government employee named
    Molly Orshansky first figured
    out the calculation for the U.S.
    poverty rate. She was a lifetime civil
    servant who had initially worked for
    the Department of Agriculture, but in
    1963, when she came up with the
    poverty measure, she was working
    for the Social Security Administration.
    She was working on a larger project
    at the Social Security Administration
    to try to understand what was happening to children in families without fathers. The result she arrived at
    became the official poverty standard

    because as she was working on this
    project, the President’s Council of
    Economic Advisers was under a
    mandate to come up with a plan for
    fighting what became known as the
    War on Poverty. At that time, there
    was no official poverty standard, so
    how could a war be waged on
    something that was not being measured? The Office of Economic Opportunity, which was under tremendous
    political pressure, announced that
    from that point on it was going to
    use the poverty measure as the official figure. However, despite its use,

    there is widespread agreement
    among the people who do research
    on poverty that this is a deeply
    flawed measure. Some of the common criticisms are that it does not
    take account of the growth of noncash benefits such as food stamps,
    does not take account of taxes, and
    does not take account of differences
    across geographical areas in the cost
    of living. Taking these factors into account can have a significant effect on
    the poverty rate.

    Another factor affecting the poverty rate is the age distribution of the population.
    The United States is becoming older; the elderly make up an increasing percentage
    of the population. The elderly have smaller incomes than the nonelderly, primarily
    because many elderly people are retired. In fact, many of the elderly have incomes
    that are less than the poverty threshold level. As a result, the aging population shows
    up as an increasing number of people living in poverty on the basis of income. At
    the same time, many of the elderly have wealth enough to enable them to live very
    well even though their income is low. It might make more sense to take the wealth
    and income levels into account when defining poverty.

    R E C A P

    1.
    2.
    3.
    4.

    A person’s income is determined by the value of the resources a person owns.
    Since not everyone owns the same resources, incomes are not equal.
    Income distribution is illustrated by a Lorenz curve.
    Poverty is defined relative to a society. Someone in poverty in the United
    States would be considered well-off in Ethiopia.
    5. The primary factor leading to poverty is a lack of a job; that is partly determined by whether the economy is growing or is in a recession.

    SUMMARY
    ?

    1.
    2.
    3.

    176

    What does economic analysis have to contribute
    to the understanding of environmental issues?

    Renewable resources are resources that can replenish
    themselves.
    Nonrenewable resources are resources whose total
    amount in existence is limited.
    The market for resources determines prices at which
    the rate of use of renewable resources allows the re-

    sources to replenish and limits the rate at which the
    nonrenewable resources are consumed.
    4.

    5.

    When an externality occurs, private costs and benefits
    differ from social costs. Either too much or too little is
    consumed or produced relative to the quantities that
    would occur if all costs and benefits were included.
    If global warming is the result of an accumulation of
    greenhouse gases, then it is due to the existence of externalities and a lack of private property rights. Too

    Part Two / Consumers, Firms, and Social Issues

    6.
    7.

    ?

    many gases are emitted because the costs are not internalized.
    If the costs of the externalities can be internalized, the
    socially desired level of emissions will result.
    Global environmental problems are more difficult
    to resolve than domestic ones because of the lack
    of property rights. When no one government owns the
    resource being damaged by an externality, then the
    externality cannot be resolved by any one government.
    Does the War on Drugs make economic sense?

    Banning or prohibiting items for which consumers
    have an elastic demand is relatively easy. Banning
    items for which demand is inelastic is another matter.
    9. The War on Drugs has raised the cost of supplying
    and selling drugs. Yet because demand is inelastic,
    consumption has not decreased much. Costs are
    passed along to consumers, who pay higher prices but
    consume nearly as much.
    10. The War on Drugs results in suppliers offering ever more
    potent forms of the drugs. In addition, the incentive to
    maintain quality of the drugs is reduced as suppliers
    seek additional profits.
    11. Crime rises as suppliers compete for turf and sales
    and consumers look for resources with which to purchase the drugs.
    12. Legalization of drugs would reduce crime and lower
    the prices of drugs, possibly leading to increased consumption. A tax on legal drugs would maintain higher
    prices and thus not increase consumption while reducing crime.

    15. Statistical discrimination is the result of imperfect information and can occur as long as information is imperfect.
    ?

    Does a minimum wage make economic sense?

    16. A minimum wage is a wage imposed by government
    that is greater than the equilibrium wage.
    17. A minimum wage reduces employment.
    18. The unskilled, usually teenagers, minorities, and
    women, bear the costs of a minimum wage.

    8.

    ?

    Does discrimination make economic sense?

    13. Discrimination occurs when some factor not related to
    an individual’s value to the firm affects the wage rate
    that person receives.
    14. Discrimination is costly to those who discriminate
    and should not last in a market economy, at least when
    entry is easy.

    ?

    Why are incomes not equally distributed?

    19. The Lorenz curve illustrates the degree of income inequality.
    20. If the Lorenz curve corresponds with the line of
    income equality, then incomes are distributed equally.
    If the Lorenz curve bows down below the line of
    income equality, then income is distributed in such a
    way that more people earn low incomes than high incomes.
    21. As a rule, incomes are distributed more unequally in
    developing countries than in developed countries.
    ?

    What does it mean to be living in poverty?

    22. Poverty is an arbitrary level of income chosen to provide a measure of how well basic human needs are being met.
    23. The incidence of poverty decreases as the economy
    grows and increases as the economy falls into
    recession.
    24. Many people fall below the poverty line for a short
    time only. However, a significant core of people remain in poverty for at least ten years.
    25. The poor are primarily those without jobs. These tend
    to be people without skills and the youngest members
    of society.

    EXERCISES
    1.

    2.
    3.
    4.

    What is the Lorenz curve? What would the curve look
    like if income were equally distributed? Could the
    curve ever bow upward above the line of income
    equality?
    Why does the health of the economy affect the number of people living in poverty?
    What would it mean if the poverty income level of the
    United States were applied to Mexico?
    Use the following information to plot a Lorenz curve.

    Chapter 8 / Social Issues

    5.

    Percentage
    of Population

    Percentage
    of Income

    20
    40
    60
    80
    100

    5
    15
    35
    65
    100

    If the incidence of poverty decreases during periods
    when the economy is growing and increases during

    177

    periods when the economy is in recession, what government policies might be used to reduce poverty
    most effectively?
    Explain what is meant by the term discrimination. Explain what statistical discrimination is.
    Why do economists say that discrimination is inherently inefficient and therefore will not occur in general?
    Use the following information to answer these four
    questions:
    a. What are the external costs per unit of output?
    b. What level of output will be produced?
    c. What level of output should be produced to achieve
    economic efficiency?
    d. What is the value to society of correcting the externality?

    6.
    7.
    8.

    Quantity

    Marginal
    Costs
    MC

    1
    2
    3
    4
    5

    Internet
    Exercise

    178

    $ 2
    4
    6
    8
    10

    Marginal
    Social
    Costs
    MSC

    Marginal
    Revenue
    MR

    $ 4
    6
    8
    10
    12

    $12
    10
    8
    6
    4

    9.

    If, in exercise 8, the MC and MSC columns were reversed, you would have an example of what? Would
    too much or too little of the good be produced?
    10. Overfishing refers to catching fish at a rate that does
    not allow the fish to repopulate. What is the fundamental problem associated with overfishing of the
    oceans? What might lead to underfishing?
    11. Compare a ban on trans fats to a ban on cocaine. What
    do the markets look like? How are they different?
    Which ban would be easier to enforce? Explain.

    The Equal Employment Opportunity Commission is charged with overseeing
    U.S. antidiscrimination laws. Use the Internet to explore the EEOC website.
    Go to the Boyes/Melvin Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise link
    for Chapter 8. Now answer the questions that appear on the Boyes/Melvin website.

    Part Two / Consumers, Firms, and Social Issues

    Study Guide for Chapter 8
    Key Term Match

    the differences between addicts and experimental users.
    ■ e. Designer drugs are extremely difficult to
    manufacture.

    Match each term with its correct definition by placing the appropriate letter next to the corresponding
    number.
    E.
    F.
    G.
    H.

    minimum wage
    income distribution
    Lorenz curve
    poverty

    1. resources that can replenish themselves
    2. an arbitrary level of income chosen to provide
    a measure of how well basic human needs are
    being met
    3. the practice of treating people differently in a market which is based on a characteristic having nothing to do with that market
    4. using characteristics that apply to a group, although not to all individual members of that
    group, as an allocation device
    5. a diagram illustrating the degree of income
    inequality
    6. the ways in which a society’s income is divided
    7. the least amount an employee can be paid according to government mandate
    8. resources that cannot replenish themselves

    100
    90
    80

    Total Income
    (cumulative percentage)

    A. renewable
    resources
    B. nonrenewable
    resources
    C. discrimination
    D. statistically
    discriminating

    Use the following graph to answer question 3.

    2

    Which of the following is a renewable resource?
    ■ a. coal
    ■ b. the rain forest
    ■ c. uranium
    ■ d. oil
    ■ e. natural gas
    Which of the following statements is true?
    ■ a. Suppliers of illicit drugs would like to see these
    drugs legalized because their costs would
    decrease.
    ■ b. The markets for cocaine and heroin have barriers to entry.
    ■ c. If illicit drugs were legalized, the drug cartels
    would make higher profits.
    ■ d. The government’s policy of eliminating drug
    “factories” and confiscating supplies addresses

    Chapter 8 / Social Issues

    60

    A

    50

    B

    40

    C

    30
    20
    10
    0

    10

    20

    30

    40

    50

    60

    70

    80

    90 100

    Total Population
    (cumulative percentage)

    3

    Which of the following statements about these Lorenz
    curves is correct?
    ■ a. Line A shows the most unequally distributed
    income.
    ■ b. Line C shows a more equal income distribution
    than line B does.
    ■ c. Line A shows a perfectly equal distribution.
    ■ d. All of the above are correct.
    ■ e. Only a and b are correct.

    4

    Relative to developed nations, less-developed nations
    have
    ■ a. the same income distribution.
    ■ b. a more unequal income distribution.
    ■ c. a more equal income distribution.
    ■ d. an almost perfectly equal income distribution.
    ■ e. an almost perfectly unequal income distribution.

    Quick-Check Quiz
    1

    70

    Practice Questions and Problems
    1

    When social costs are higher than private costs, the
    market produces
    not enough) of the product.

    (too much,

    179

    2

    When

    private

    property

    rights

    are

    graph, draw the Lorenz curves for the two countries.
    The country with the more equal income distribution

    ill-defined,

    (too much, too little) of a re-

    is

    source is consumed.

    4

    When positive externalities exist,
    (too much, too little) of a good is consumed or
    produced.
    The demand for illicit drugs by hard-core users is
    price

    5

    6

    (elastic, inelastic).

    Legalizing drugs would
    (increase, decrease) the costs of production and
    (increase, decrease) the profThe U.S. antidrug effort consists of trying to reduce
    the
    illegal drugs.

    Third Fourth Highest
    20%
    20%
    20%
    12
    20
    58
    18
    25
    40

    100

    The lower the price elasticity of demand the
    (easier, tougher) is it to ban
    illegal drugs.

    its made by drug cartels.
    7

    Lowest Second
    20%
    20%
    Mexico
    3
    7
    United States 5
    12

    90
    80

    Total Income
    (cumulative percentage)

    3

    .

    (supply of, demand for)

    70
    60
    50
    40
    30
    20
    10

    8

    When drug dealers’ costs rise, they pass these costs
    to consumers if demand is
    inelastic).

    9

    0

    (elastic,

    Discrimination based on personal prejudice is usually

    10

    20

    30

    40

    50

    60

    70

    80

    90 100

    Total Population
    (cumulative percentage)

    15 In terms of age, the highest incidence of poverty is for

    (costly, profitable) for a firm.

    .

    10 When entry is

    (easy, difficult), having higher costs due to discrimination may
    drive a firm out of the market.

    11 Which groups are likely to suffer unemployment

    as a result of increases in the minimum wage law?

    12 An increase in the minimum wage is likely to

    (increase, decrease) teenage
    employment.
    13 The minimum wage is a price

    (ceiling, floor).
    14 The following table gives income distribution data for

    the United States and Mexico. On the following

    180

    Exercises and Applications
    I

    Comparable Worth and High School Teachers

    Labor markets in the United States frequently have resulted in wage patterns that seem discriminatory; minorities and women, on average, are paid substantially
    less than white males. One approach (known as comparable worth) to making wage patterns more equal is to
    disregard the market forces of demand and supply and
    to set wages for jobs based on job characteristics. Using
    this approach, people who hold jobs that take place in
    the same sort of environment, that require the same level
    of responsibility, and that require the same amount of
    education should receive the same rate of pay.
    The job market for high school teachers in most of
    the United States has worked this way for many years.

    Part Two / Consumers, Firms, and Social Issues

    In most high schools, teachers with the same education
    and years of experience are paid the same salary, regardless of the subject area they teach. This practice
    fits the comparable worth idea: The working conditions and demands on English teachers are the same as
    those for math teachers. But ignoring demand and supply has some economic effects worth looking at.

    2. If the schools maintain equal salaries for all teachers, English teachers also will receive a salary of
    $35,000. Mark on graph (b) the quantity demanded
    and quantity supplied of English teachers when the
    salary is $35,000. Explain what will happen in the
    market for English teachers if their salaries are
    raised to $35,000.

    1. Suppose U.S. high schools decide to improve the
    training of skilled workers by requiring students to
    take more math classes. The following graphs show
    the demand and supply (D1 and S1) for math teachers and English teachers before adding math
    classes, with both math and English teachers earning $30,000, and a new demand curve (D2) for math
    teachers after adding more math classes. Mark on
    graph (a) the old and new equilibrium salary and
    number of math teachers.

    3. One of the most useful characteristics of a market
    economy is that price changes signal changes in
    the relative scarcity of different products and resources and encourage people to respond to those
    changes. Can you think of any ways that labor
    markets, by setting salaries based on comparable
    worth, can do the same thing without having math
    teachers receiving higher salaries than English
    teachers?

    a. The market equilibrium salary for math teachers
    now is
    .
    b. Using the ideas presented in this chapter and
    the previous one, explain why the salary has to
    go up to attract new math teachers.

    II

    S1

    40

    35
    30
    25
    20
    15

    D2

    10

    D1

    5
    10

    20

    30

    40

    50

    60

    70

    80

    Quantity (number of math teachers)
    (thousands)

    Chapter 8 / Social Issues

    Wage Rate per Year
    (thousands of dollars)

    40

    Wage Rate per Year
    (thousands of dollars)

    Walter
    Williams, an economist and columnist, was quoted in

    (b) Market for English Teachers

    (a) Market for Math Teachers

    0

    Discrimination and Minimum Wage Laws

    S1

    35
    30
    25
    20
    15
    10

    D1

    5
    90 100

    0

    10

    20

    30

    40

    50

    60

    70

    80

    90 100

    Quantity (number of English teachers)
    (thousands)

    181

    The article also points out that about 16 percent of the
    people in New York City receive cash payments from
    public assistance programs, compared with fewer than
    8 percent for the United States as a whole.

    the Wall Street Journal as saying, “The brunt of the
    minimum wage law is borne by low-skilled workers . . .
    particularly black teenagers.” In this chapter, we have
    found that discrimination in competitive labor markets
    is usually costly to employers and that minimum wage
    laws can create a labor surplus in competitive labor
    markets. Use these two ideas to explain the logic behind Williams’s comment. (Hint: Think about the effects that a surplus has on the costs of discriminating.)

    1. Use what you have learned in this chapter and in
    previous chapters about the supply of labor to explain why generous welfare programs in New York
    City might increase the number of people living in
    poverty in New York.

    III Welfare, Workfare, and Incentives to Work

    182 Chapter 8 / Social Issues

    2. How would a workfare program change incentives? Do you think workfare is a good idea or a
    bad idea? Why?

    ✸✔

    ACE s

    In a
    story entitled “Problem of the Poor,” New York Newsday stated:
    Liberal critics and welfare-rights groups point
    to [New York’s] high poverty rate—60 percent
    above the national average—citing inadequate
    welfare benefits, a lack of public housing and
    other holes in the safety net. Yet New York has
    provided some of the most generous welfare
    benefits in the country, both in terms of the
    amount of benefits offered and the number of
    people covered. . . . The level of cash benefits
    in the basic welfare program is 50 percent
    above that of the median state in the United
    States.

    -test
    elf

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    Part Two / Consumers, Firms, and Social Issues 182

    This page intentionally left blank

    Part Three

    The National and Global Economies

    CHAPTER 9

    An Overview of the National and International Economies
    1.
    2.
    3.
    4.
    5.

    What is a household, and what is household income and spending?
    What is a business firm, and what is business spending?
    How does the international sector affect the economy?
    What does government do?
    How do the three private sectors—households, businesses, and the international
    sector—interact in the economy?
    6. How does the government interact with the other sectors of the economy?

    CHAPTER 10

    Macroeconomic Measures
    1.
    2.
    3.
    4.
    5.

    CHAPTER 11

    Unemployment, Inflation, and Business Cycles
    1.
    2.
    3.
    4.
    5.

    CHAPTER 12

    How is the total output of an economy measured?
    What is the difference between nominal and real GDP?
    What is the purpose of a price index?
    How is money traded internationally?
    How do nations record their transactions with the rest of the world?

    What is a business cycle?
    How is the unemployment rate defined and measured?
    What is the cost of unemployed resources?
    What is inflation?
    Why is inflation a problem?

    Macroeconomic Equilibrium: Aggregate Demand and Supply
    1.
    2.
    3.
    4.

    What is aggregate demand?
    What causes the aggregate demand curve to shift?
    What is aggregate supply?
    Why does the short-run aggregate supply curve become steeper as real GDP
    increases?
    5. Why is the long-run aggregate supply curve vertical?
    6. What causes the aggregate supply curve to shift?
    7. What determines the equilibrium price level and real GDP?

    CHAPTER 13

    Fiscal Policy
    1.
    2.
    3.
    4.

    CHAPTER 14

    How can fiscal policy eliminate a GDP gap?
    How has U.S. fiscal policy changed over time?
    What are the effects of budget deficits?
    How does fiscal policy differ across countries?

    Money and Banking
    1.
    2.
    3.
    4.
    5.
    6.

    What is money?
    How is the U.S. money supply defined?
    How do countries pay for international transactions?
    Why are banks considered intermediaries?
    How does international banking differ from domestic banking?
    How do banks create money?

    185

    Chapter 9

    ?

    Fundamental
    Questions

    1. What is a household,
    and what is
    household income
    and spending?
    2. What is a business
    firm, and what is
    business spending?
    3. How does the
    international sector
    affect the economy?
    4. What does
    government do?
    5. How do the three
    private sectors—
    households,
    businesses, and the
    international sector—
    interact in the
    economy?
    6. How does the
    government interact
    with the other
    sectors of the
    economy?

    An Overview of the National
    and International Economies

    Y

    ou decide to buy a new Toyota, so you go
    to a Toyota dealer and exchange money
    for the car. The Toyota dealer has rented
    land and buildings and hired workers in order to make cars available to you and
    other members of the public. The employees earn income paid by the Toyota dealer
    and then use their incomes to buy food from the grocery store. This transaction
    generates revenue for the grocery store, which hires workers and pays them incomes that they then use to buy groceries and Toyotas. Your expenditure for the
    Toyota is part of a circular flow. Revenue is received by the Toyota dealer, who
    pays employees, who, in turn, buy goods and services.
    Of course, the story is complicated by the fact that the Toyota is originally manufactured and purchased in Japan and then shipped to the United States before it
    can be sold by the local Toyota dealer. Your purchase of the Toyota creates revenue
    for the local dealer as well as for the manufacturer in Japan, which pays Japanese
    autoworkers to produce Toyotas. Furthermore, when you buy your Toyota, you
    must pay a tax to the government, which uses tax revenues to pay for police protection, national defense, the legal system, and other services. Many people in different areas of the economy are involved.
    An economy is made up of individual buyers and sellers. Economists could discuss the neighborhood economy that surrounds your university, the economy of the
    city of Chicago, or the economy of the state of Massachusetts. But typically it is the
    national economy, the economy of the United States, that is the center of their attention. To clarify the operation of the national economy, economists usually group
    individual buyers and sellers into sectors: households, businesses, government, and
    the international sector. Since the U.S. economy affects, and is affected by, the rest
    of the world, to understand how the economy functions, we must include the international sector. In this chapter we examine basic data and information on each individual sector and examine how the sectors interact. ■

    Preview

    1. HOUSEHOLDS
    household: one or more
    persons who occupy a unit of
    housing

    186

    A household consists of one or more persons who occupy a unit of housing. The
    unit of housing may be a house, an apartment, or even a single room, as long as it

    Part Three / The National and Global Economies

    The graph reveals that householders aged 35 to 44 make
    up the largest number of
    households, and householders aged 45 to 54 earn the
    highest median annual
    income.
    Source: U.S. Department of
    Commerce, Income in the
    United States: 2005,
    http://www.census.gov.

    30

    Total Households (millions)

    Age of Householder,
    Number of Households, and
    Median Household Income
    in the United States

    70

    Median Income

    25

    60
    50

    20

    Total Households
    40

    15
    30
    10

    20

    5

    10

    15 – 24

    25 – 34

    35 – 44

    45 – 54

    55 – 64

    Median Annual Income (thousand dollars)

    Figure 1

    65 +

    Age of Householder

    constitutes separate living quarters. A household may consist of related family
    members, like a father, mother, and children, or it may comprise unrelated individuals, like three college students sharing an apartment. The person in whose name
    the house or apartment is owned or rented is called the householder.

    ?
    1. What is a household,
    and what is household
    income and spending?

    1.a. Number of Households and Household Income
    In 2005, there were more than 112 million households in the United States.
    The breakdown of households by age of householder is shown in Figure 1. Householders between 35–44 and 45–54 years old make up the largest number of households. Householders between 45 and 54 years old have the largest median income.
    The median is the middle value—half of the households in an age group have an income higher than the median, and half have an income lower than the median.
    Figure 1 shows that households in which the householder is between 45 and 54
    years old have a median income of about $62,000, substantially higher than the
    median incomes of other age groups. Typically, workers in this age group are at the
    peak of their earning power. Younger households are gaining experience and training;
    older households include retired workers.
    Thirty-three percent of all households are two-person households. The stereotypical household of husband, wife, and two children accounts for only 14 percent
    of all households. There are relatively few large households in the United States.
    Of the more than 112 million households in the country, only about 1 percent have
    seven or more persons.

    1.b. Household Spending
    consumption: household
    spending

    Household spending is called consumption. Householders consume housing,
    transportation, food, entertainment, and other goods and services. Household
    spending (also called consumer spending) is the largest component of total spending in the economy—rising to about $9.3 trillion in 2006.

    Chapter 9 / An Overview of the National and International Economies

    187

    R E C A P

    ?
    2. What is a business firm,
    and what is business
    spending?

    1. A household consists of one or more persons who occupy a unit of
    housing.
    2. An apartment or house is rented or owned by a householder.
    3. As a group, householders between the ages of 45 and 54 have the highest median incomes.
    4. Household spending is called consumption.

    2. BUSINESS FIRMS
    A business firm is a business organization controlled by a single management. The
    firm’s business may be conducted at more than one location. The terms company,
    enterprise, and business are used interchangeably with firm.

    2.a. Forms of Business Organizations

    multinational business: a
    firm that owns and operates
    producing units in foreign
    countries

    Firms are organized as sole proprietorships, partnerships, or corporations. A sole proprietorship is a business owned by one person. This type of firm may be a one-person
    operation or a large enterprise with many employees. In either case, the owner receives all the profits and is responsible for all the debts incurred by the business.
    There is no separation between the owner and the firm in that the owner has unlimited liability for the firm’s debts, and profits are taxed at the owner’s individual income tax rate. However, the owner also has sole control over business decisions.
    A partnership is a business owned by two or more partners who share both the
    profits of the business and responsibility for the firm’s losses. The partners could be
    individuals, estates, or other businesses. Partners owning a firm have unlimited liability for firm debts and are taxed at individual tax rates.
    State law allows the formation of corporations. A corporation is a business whose
    identity in the eyes of the law is distinct from the identity of its owners. A corporation is
    an economic entity that, like a person, can own property and borrow money in its own
    name. The owners of a corporation are shareholders. If a corporation cannot pay its
    debts, creditors cannot seek payment from the shareholders’ personal wealth. The corporation itself is responsible for all its actions. The shareholders’ liability is limited to
    the value of the stock they own. Corporations are taxed at corporate income tax rates. In
    many corporations there are many shareholders who exercise no control over the firm.
    A separation of ownership and control may occur when the professional managers of
    the firm are different individuals than those who own large amounts of stock.
    Many firms are global in their operations even though they may have been founded
    and may be owned by residents of a single country. Firms typically first enter the international market by selling products to foreign countries. As revenues from these
    sales increase, the firms realize advantages by locating subsidiaries in foreign countries. A multinational business is a firm that owns and operates producing units in
    foreign countries. The best-known U.S. corporations are multinational firms. Ford,
    IBM, PepsiCo, and McDonald’s all own operating units in many different countries.
    Ford Motor Company, for instance, is the parent firm of sales organizations and assembly plants located around the world. As transportation and communication technologies progress, multinational business activity will grow.

    2.b. Business Statistics
    There are far more sole proprietorships than partnerships or corporations in the
    United States. The great majority of sole proprietorships are small businesses, with
    revenues under $25,000 a year. Similarly, more than half of all partnerships also

    188

    Part Three / The National and Global Economies

    have revenues under $25,000 a year, but only 23 percent of the corporations are in
    this category.
    The 68 percent of sole proprietorships that earn less than $25,000 a year account
    for only 9 percent of the revenue earned by proprietorships. The 0.4 percent of proprietorships with revenue of $1 million or more account for 19 percent. Even more
    striking are the figures for partnerships and corporations. The 58 percent of partnerships with the smallest revenue account for only 0.4 percent of the total revenue
    earned by partnerships. At the other extreme, the 5 percent of partnerships with the
    largest revenue account for 88 percent of total partnership revenue. The 23 percent of
    corporations in the smallest range account for less than 0.1 percent of total corporate
    revenue, while the 18 percent of corporations in the largest range account for 94
    percent of corporate revenue.
    Big business is important in the United States. There are many small firms, but
    large firms and corporations account for the greatest share of business revenue.
    Although there are only about one-third as many corporations as sole proprietorships, corporations have more than 15 times the revenue of sole proprietorships.

    2.c. Firms Around the World
    Big business is a dominant force in the United States. Many people believe that because the United States is the world’s largest economy, U.S. firms are the largest in
    the world. Figure 2 shows that this is not entirely true. Of the ten largest corporations in the world (measured by sales), four are outside the United States. Big business is not just a U.S. phenomenon.

    2.d. Business Spending
    investment: spending on
    capital goods to be used in
    producing goods and services

    Figure 2

    Investment is the expenditure by business firms for capital goods—machines,
    tools, and buildings—that will be used to produce goods and services. The economic meaning of investment is different from the everyday meaning, “a financial
    transaction such as buying bonds or stocks.” In economics, the term investment
    refers to business spending for capital goods.

    Rank Firm (country)

    The World’s Ten Largest
    Public Companies

    1

    Exxon Mobil (U.S.)

    As shown in the chart, large
    firms are not just a U.S.
    phenomenon.

    2

    Wal-Mart Stores (U.S.)

    312

    3

    Royal Dutch/ Shell Group (Netherlands)

    307

    4

    British Petroleum (U.K.)

    249

    5

    General Motors (U.S.)

    193

    6

    Chevron (U.S.)

    185

    7

    Ford Motor (U.S.)

    178

    8

    DaimlerChrysler (Germany/U.S.)

    177

    9

    Toyota Motor (Japan)

    173

    10

    ConocoPhillips (U.S.)

    162

    $328

    0

    50 100 150 200 250 300 350

    Sales (billions)
    Source: “The Forbes 2000,” http://www.forbes.com. Reprinted by permission of Forbes
    Magazine. Copyright © 2007 Forbes LLC.

    Chapter 9 / An Overview of the National and International Economies

    189

    Investment spending in 2006 was $2,218 billion, an amount equal to roughly
    one-fifth of consumption, or household spending. Investment increases unevenly,
    actually falling at times and then rising very rapidly. Even though investment
    spending is much smaller than consumption, the wide swings in investment spending mean that business expenditures are an important factor in determining the economic health of the nation.

    R E C A P

    ?
    3. How does the international sector affect the
    economy?

    1. Business firms may be organized as sole proprietorships, partnerships, or
    corporations.
    2. Large corporations account for the largest fraction of total business
    revenue.
    3. Business investment spending fluctuates widely over time.

    3. THE INTERNATIONAL SECTOR
    Today, foreign buyers and sellers have a significant effect on economic conditions
    in the United States, and developments in the rest of the world often influence
    U.S. buyers and sellers. We saw in previous chapters, for instance, how exchange
    rate changes can affect the demand for and supply of U.S. goods and services.

    3.a. Types of Countries
    The nations of the world may be divided into two categories: industrial countries
    and developing countries. Developing countries greatly outnumber industrial countries (see Figure 3). The World Bank (an international organization that makes
    loans to developing countries) groups countries according to per capita income
    (income per person). Low-income economies are those with per capita incomes
    of $755 or less. Lower-middle-income economies have per capita incomes of
    $756 to $2,995. Upper-middle-income economies have per capita incomes of
    $2,996 to $9,265. High-income economies—oil exporters and industrial market
    economies—have per capita incomes of greater than $9,266. Some countries
    are not members of the World Bank and so are not categorized, and information
    about a few small countries is so limited that the World Bank is unable to classify
    them.
    It is readily apparent from Figure 3 that low-income economies are heavily concentrated in Africa while lower-middle-income economies are heavily concentrated
    in Asia. Countries in these regions have a low profile in U.S. trade, although they
    may receive aid from the United States. The U.S. trade is concentrated with its
    neighbors Canada and Mexico, along with the major industrial powers.
    3.a.1. The Industrial Countries The richest industrial market economies are
    listed in the bar chart in Figure 4. The countries listed in Figure 4 are among the
    wealthiest countries in the world. Not appearing on the list are the high-income oilexporting nations like Libya, Saudi Arabia, Kuwait, and the United Arab Emirates,
    which are considered to still be developing.
    The economies of the industrial nations are highly interdependent. As conditions
    change in one nation, business firms and individuals looking for the best return or
    interest rate on their funds may shift large sums of money from one country to others. As they do, economic conditions in one country spread to other countries. As a
    result, the industrial countries, particularly the major economic powers like the
    United States, Germany, and Japan, are forced to pay close attention to each other’s
    economic policies.

    190

    Part Three / The National and Global Economies

    imports: products that a
    country buys from other
    countries
    exports: products that a
    country sells to other countries

    3.a.2. The Developing Countries Referring back to Figure 3, we see that the
    developing countries (sometimes referred to as the less-developed countries, or
    LDCs) are classified as low or middle income. These countries differ greatly in
    terms of the provision of basic human needs to the average citizen. A major way that
    such countries can raise living standards is by selling goods to the rest of the world.
    The United States tends to buy, or import, primary products such as agricultural
    produce and minerals from the developing countries. Products that a country buys
    from another country are called imports. The United States tends to sell, or export,
    manufactured goods to developing countries. Products that a country sells to another
    country are called exports. The United States is the largest producer and exporter of
    grains and other agricultural output in the world. The efficiency of U.S. farming relative to farming in much of the rest of the world gives the United States a comparative advantage in many agricultural products.

    3.b. International Sector Spending

    trade surplus: the situation
    that exists when imports are
    less than exports
    trade deficit: the situation
    that exists when imports
    exceed exports
    net exports: the difference
    between the value of exports
    and the value of imports

    R E C A P

    Economic activity of the United States with the rest of the world includes U.S.
    spending on foreign goods and foreign spending on U.S. goods. Figure 5 shows how
    U.S. exports and imports are spread over different countries. Trade with Western
    Europe, Canada, and Japan accounts for about half of U.S. trade.
    When exports exceed imports, a trade surplus exists. When imports exceed
    exports, a trade deficit exists. Figure 5 shows that the United States is importing
    much more than it exports.
    The term net exports refers to the difference between the value of exports and
    the value of imports: net exports equals exports minus imports. Positive net exports
    represent trade surpluses; negative net exports represent trade deficits. In 2006,
    U.S. net exports were −$762 billion.

    1. The majority of U.S. trade is with the industrial market economies.
    2. Exports are products sold to foreign countries; imports are products bought
    from foreign countries.
    3. Exports minus imports equals net exports.
    4. Positive net exports signal a trade surplus; negative net exports signal a trade
    deficit.

    4. OVERVIEW OF THE U.S. GOVERNMENT
    ?
    4. What does government
    do?

    When Americans think of government policies, rules, and regulations, they
    typically think of Washington, D.C., because their economic lives are regulated and
    shaped more by policies made there than by policies made at the state and local levels.
    Who actually is involved in economic policymaking? Important government institutions that shape U.S. economic policy are listed in Table 1. This list is far from inclusive, but it does include the agencies with the broadest powers and greatest influence.
    Economic policy involves macroeconomic issues like government spending and control of the money supply and microeconomic issues aimed at providing public goods
    like police and military protection and correcting problems such as pollution.

    4.a. Government Policy
    The government has been given many functions in the economy. These include providing some goods, regulating some firm behaviors, and promoting competition via
    laws restricting the ability of business firms to engage in certain practices.

    Chapter 9 / An Overview of the National and International Economies

    191

    Figure 3
    World Economic
    Development
    The colors on the map identify low-income, middleincome, and high-income
    economies. Countries have
    been placed in each group
    on the basis of GNP per
    capita and, in some instances, other distinguishing
    economic characteristics.

    N o r t h
    A m e r i c a

    Source: World Bank,
    http://www.worldbank.org

    S o u t h
    A m e r i c a
    Low-income economies
    $755 or less
    Lower-middle-income economies
    $756 to $2,995
    Upper-middle-income economies
    $2,996 to $9,265
    High-income economies
    $9,266 or more
    No data

    monetary policy: policy
    directed toward the control of
    money and credit
    Federal Reserve: the central
    bank of the United States

    fiscal policy: policy directed
    toward government spending
    and taxation

    192

    Most attention is given to the government’s monetary and fiscal policies.
    Monetary policy is policy directed toward the control of money and credit. The
    major player in this policy arena is the Federal Reserve, commonly called the Fed.
    The Federal Reserve is the central bank of the United States. It serves as a banker
    for the U.S. government and regulates the U.S. money supply.
    The Federal Reserve System is run by a seven-member Board of Governors. The
    most important member of the board is the chairman, who is appointed by the president for a term of four years. The board meets regularly (from 10 to 12 times a
    year) with a group of high-level officials to review the current economic situation
    and set policy for the growth of U.S. money and credit. The Federal Reserve exercises a great deal of influence on U.S. economic policy.
    Fiscal policy, the other area of macroeconomic policy, is policy directed toward
    government spending and taxation. In the United States, fiscal policy is determined
    by laws that are passed by Congress and signed by the president. The relative roles
    of the legislative and executive branches in shaping fiscal policy vary with the political climate, but usually it is the president who initiates major policy changes.
    Presidents rely on key advisers for fiscal policy information. These advisers include cabinet officers such as the Secretary of the Treasury and the Secretary of
    State as well as the Director of the Office of Management and Budget. In addition,
    the president has a Council of Economic Advisers made up of three economists—

    Part Three / The National and Global Economies

    A s i a
    E u r o p e

    A f r i c a

    A u s t r a l i a

    usually a chair, a macroeconomist, and a microeconomist—who, together with
    their staff, monitor and interpret economic developments for the president. The
    degree of influence wielded by these advisers depends on their personal relationship with the president.

    4.b. Government Spending

    transfer payments: income
    transferred from one citizen
    who is earning income to
    another citizen who may
    not be

    Federal, state, and local government spending for goods and services between 1959
    and 2004 is shown in Figure 6. Except during times of war in the 1940s and 1950s,
    federal expenditures were roughly similar in size to state and local expenditures
    until 1970. Since 1970, state and local spending has been growing more rapidly
    than federal spending.
    Combined government spending on goods and services is larger than investment
    spending but much smaller than consumption. In 2006, combined government
    spending was $2,526 billion, investment spending was $2,218 billion, and consumption was $9,271 billion.
    Besides government expenditures on goods and services, government also serves
    as an intermediary, taking money from taxpayers with higher incomes and transferring this income to those with lower incomes. Such transfer payments are a part
    of total government expenditures, so the total government budget is much larger
    than the expenditures on goods and services reported in Figure 6. In 2006, total

    Chapter 9 / An Overview of the National and International Economies

    193

    Figure 4

    Country

    The Industrial Market
    Economies

    Norway
    Switzerland
    United States
    Denmark
    Japan
    Sweden
    Ireland
    United Kingdom
    Finland
    Austria
    Netherlands
    Belgium
    Germany
    France
    Canada
    Australia
    Hong Kong
    Italy
    Singapore
    Spain
    New Zealand
    Israel
    Portugal

    The bar chart lists some of
    the wealthiest countries in
    the world. Ironically, highincome oil-exporting countries such as Libya, Saudi
    Arabia, Kuwait, and the
    United Arab Emirates do not
    appear on the list because
    they are still considered to be
    developing.

    $51,810
    49,600
    41,440
    40,750
    37,050
    35,840
    34,310
    33,630
    32,880
    32,280
    32,130
    31,280
    30,690
    30,370
    28,310
    27,070
    26,660
    26,280
    24,760
    21,530
    19,990
    17,360
    14,220
    0

    5

    10

    15

    20

    25

    30

    35

    40

    45

    50

    55

    Income per Person (thousands of 1998 U.S. dollars)
    Source: World Bank, World Development Report, 2006;
    http://devdata.worldbank.org/data_query.

    budget surplus: the excess
    that results when government
    spending is less than revenue
    budget deficit: the shortage
    that results when government
    spending is greater than
    revenue

    194

    expenditures of federal, state, and local government for goods and services were
    $2,526 billion. In this same year, transfer payments paid by all levels of government were $1,593 billion.
    The magnitude of federal government spending relative to federal government
    revenue from taxes has been a major issue in recent U.S. national elections. Figure
    7 shows that the federal budget was roughly balanced until the early 1970s. The
    budget is a measure of spending and revenue. A balanced budget occurs when federal spending is approximately equal to federal revenue. This was the case through
    the 1950s and 1960s. If federal government spending is less than tax revenue, a
    budget surplus exists. Until 1998, the U.S. government last had a budget surplus
    in 1969. By the early 1980s, federal government spending was much larger than
    revenue, so a large budget deficit existed. The federal budget deficit grew very
    rapidly to well over $200 billion by the early 1990s. When spending is greater than
    revenue, the excess spending must be covered by borrowing, and this borrowing
    can have effects on investment and consumption as well as on economic relationships with other countries. In the late 1990s, the budget deficit dropped rapidly as
    strong economic growth generated tax revenues that grew more rapidly than expenditures, and a surplus was realized by 1998. However, by 2002, the budget had returned to a deficit.

    Part Three / The National and Global Economies

    Figure 5
    Direction of U.S. Trade

    Canada accounts for about 44 percent of U.S. exports and
    38 percent of U.S. imports.

    This chart shows that a trade deficit exists for the United
    States, since U.S. imports greatly exceed U.S. exports. The
    chart also shows that trade with Japan, Mexico, and

    Source: Economic Report of the President, 2006;
    www.census.gov/foreign_trade.

    Industrial Countries:
    Canada
    Japan
    Western Europe
    Other
    Other Countries
    Mexico
    China
    Oil Exporters

    $844

    U.S. Exports to:

    $1,643

    U.S. Imports from:

    0

    100

    200

    300

    400

    500

    600

    700

    800

    900

    1,000 1,100 1,200 1,300 1,400 1,500 1,600

    Billions of U.S. Dollars

    Table 1

    Institution

    U.S. Government Economic
    Policymakers and Related
    Agencies

    Fiscal policymakers

    Role

    President

    Provides leadership in formulating fiscal policy

    Congress

    Sets government spending and taxes and
    passes laws related to economic conduct

    Monetary policymaker
    Federal Reserve

    Controls money supply and credit conditions

    Related agencies
    Council of Economic Advisers

    Monitors the economy and advises the
    president

    Office of Management
    and Budget

    Prepares and analyzes the federal budget

    Treasury Department

    Administers the financial affairs of the federal
    government

    Commerce Department

    Administers federal policy regulating industry

    Justice Department

    Enforces legal setting of business

    Comptroller of the Currency

    Oversees national banks

    International Trade
    Commission

    Investigates unfair international trade practices

    Federal Trade Commission

    Administers laws related to fair business
    practices and competition

    Chapter 9 / An Overview of the National and International Economies

    195

    Figure 6

    In the 1950s and early 1960s,
    federal government spending
    was above state and local
    government spending. In
    1971, state and local expenditures rose above federal
    spending and have remained
    higher ever since.
    Source: Data are from the
    Economic Report of the President, 2005.

    1,200

    U.S. Government Spending (billion dollars)

    Federal, State, and Local
    Government Expenditures
    for Goods and Services

    State and Local

    1,000
    800

    Federal

    600
    400
    200
    0
    1962 '65 '68 '71 '74 '77 '80 '83 '86 '89 '92 '95 '98 '01 2004

    Year

    R E C A P

    1. The microeconomic functions of government focus on issues aimed at providing public goods like police and military protection and correcting problems like pollution.
    2. Macroeconomic policy attempts to control the economy through monetary
    and fiscal policies.
    3. The Federal Reserve conducts monetary policy. Congress and the president
    formulate fiscal policy.
    4. Government spending is larger than investment spending but much smaller
    than consumption spending.
    5. When government spending exceeds tax revenue, a budget deficit exists.
    When government spending is less than tax revenue, a budget surplus exists.

    5. LINKING THE SECTORS
    private sector: households,
    businesses, and the
    international sector

    Now that we have an idea of the size and structure of each private sector—
    households, businesses, and international—and the government, also known as the
    public sector, let’s discuss how the sectors interact.

    public sector: the government

    5.a. The Private Sector
    Households own all the basic resources, or factors of production, in the economy.
    Household members own land and provide labor, and they are the entrepreneurs,
    stockholders, proprietors, and partners who own business firms.
    Households and businesses interact with each other by means of buying and
    selling. Businesses employ the services of resources in order to produce goods and
    services. Business firms pay households for their services of resources.
    Households sell their resource services to businesses in exchange for money
    payments. The flow of resource services from households to businesses is shown

    196

    Part Three / The National and Global Economies

    Figure 7
    The budget deficit is equal to
    the excess of government
    spending over tax revenue. If
    taxes are greater than government spending, a budget surplus (shown as a negative
    deficit) exists. The United
    States has run a budget
    deficit for all but two years
    in the period 1959 to 1997.
    Starting in 1998, a budget
    surplus appeared for four
    years.

    U.S. Federal Budget Deficits (billion dollars)

    U.S. Federal Budget Deficits
    300
    200
    100
    0
    –100
    –200
    –300
    –400
    –500

    r
    60 962 964 966 968 970 972 974 976 rte 978 980 982 984 986 988 990 992 994 996 998 000 002 004 006
    1 1 1 1 1 1 1 1 ua 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2
    q
    on
    iti
    ns
    a
    Tr

    19

    Year

    Source: Data are from the Economic Report of the President, 2005.

    ?
    5. How do the three private
    sectors—households,
    businesses, and the
    international sector—
    interact in the
    economy?

    circular flow diagram: a
    model showing the flow of
    output and income from
    one sector of the economy
    to another

    by the blue arrow beneath the sectors of households, government, and firms shown
    in Figure 8. The flow of money payments from firms to households is shown by the
    gold arrow under Resource Services. Households use the money payments to buy
    goods and services from firms. These money payments are the firms’ revenues. The
    flow of money payments from households to firms is shown by the gold arrow near
    the top of the diagram. The flow of goods and services from firms to households is
    shown by the blue arrow under Payments for Goods and Services. There is, therefore, a flow of money and goods and services from one sector to the other. The payments made by one sector are the receipts taken in by the other sector. Money,
    goods, and services flow from households to firms and back to households in a circular flow.
    Households do not spend all of the money they receive. They save some fraction of
    their income. In Figure 8, we see that household saving is deposited in financial intermediaries like banks, credit unions, and savings and loan firms. A financial intermediary accepts deposits from savers and makes loans to borrowers. The money that is
    saved by the households reenters the economy in the form of investment spending as
    business firms borrow for expansion of their productive capacity.
    To simplify this circular flow diagram, let’s assume that households are not directly engaged in international trade and that only business firms are buying and
    selling goods and services across international borders. This assumption is not far
    from the truth for the industrial countries and for many developing countries. We
    typically buy a foreign-made product from a local business firm rather than directly
    from the foreign producer.
    The lines Net Exports and Payments for Net Exports connect firms and foreign countries in Figure 8. Notice that neither line has an arrow indicating the
    direction of flow as do the other lines in the diagram. The reason is that net exports
    of the home country may be either positive (a trade surplus) or negative (a
    trade deficit). When net exports are positive, there is a net flow of goods from the

    Chapter 9 / An Overview of the National and International Economies

    197

    Figure 8
    The Circular Flow: Households, Firms, Government,
    and Foreign Countries
    The diagram assumes that households and government
    are not directly engaged in international trade. Domestic
    firms trade with firms in foreign countries. The government sector buys resource services from households and
    goods and services from firms. This government spending

    represents income for the households and revenue for
    the firms. The government uses the resource services and
    goods and services to provide government services for
    households and firms. Households and firms pay taxes
    to the government to finance government expenditures.

    Financial
    Intermediaries

    Saving ($)

    Investment ($)

    Payments for Goods and Services ($)
    Goods and Services

    Taxes ($)
    Households

    Taxes ($)

    Government Services

    Government

    Resource Services

    Government Services

    Firms

    Goods and Services

    Payments for Resource Services ($)

    Payments for Goods and Services ($)

    Resource Services
    Payments for Resource Services ($)

    Foreign Countries

    Exports
    Imports

    Net Exports

    Payments for Net Exports ($)

    firms of the home country to foreign countries and a net flow of money from foreign countries to the firms of the home country. When net exports are negative, the
    opposite occurs. A trade deficit involves a net flow of goods from foreign countries
    to the firms of the home country and a net flow of money from firms in the home
    country to foreign countries. If exports and imports are equal, net exports are zero
    because the value of exports is offset by the value of imports.

    198

    Part Three / The National and Global Economies

    5.b. The Public Sector

    ?
    6. How does the government interact with the
    other sectors of the
    economy?

    R E C A P

    Government at the federal, state, and local levels interacts with both households
    and firms. Because the government employs factors of production to produce
    government services, households receive payments from the government in
    exchange for the services of the factors of production. The flow of resource
    services from households to government is illustrated by the blue arrow from
    households to government in Figure 8. The flow of money from government to
    households is shown by the gold arrow from government to households. We
    assume that government, like a household, does not trade directly with foreign
    countries but obtains foreign goods from domestic firms that do trade with the rest
    of the world.
    Households pay taxes to support the provision of government services, such as
    national defense, education, and police and fire protection. In a sense, then, the
    household sector is purchasing goods and services from the government as well as
    from private businesses. The flow of tax payments from households and firms to
    government is illustrated by the gold arrows from households and firms to government, and the flow of government services to households and firms is illustrated by
    the purple arrows coming from government.
    The addition of government brings significant changes to the model. Households have an additional place to sell their resources for income, and businesses
    have an additional market for goods and services. The value of private production
    no longer equals the value of household income. Households receive income from
    government in exchange for providing resource services to government. The total
    value of output in the economy is equal to the total income received, but government is included as a source of income and a producer of services.

    1. The circular flow diagram illustrates how the main sectors of the economy fit
    together.
    2. Government interacts with both households and firms. Households get government services and pay taxes; they provide resource services and receive
    income. Firms sell goods and services to government and receive income.
    3. The circular flow diagram shows that the value of output is equal to income.

    SUMMARY
    ?

    1.
    2.

    ?

    3.
    4.

    What is a household, and what is household
    income and spending?

    A household consists of one or more persons who occupy a unit of housing.
    Household spending is called consumption and is the
    largest component of spending in the economy.
    What is a business firm, and what is business
    spending?

    A business firm is a business organization controlled
    by a single management.
    Businesses may be organized as sole proprietorships,
    partnerships, or corporations.

    5.

    ?

    6.
    7.
    8.

    Business investment spending—the expenditure by
    business firms for capital goods—fluctuates a great
    deal over time.
    How does the international sector affect the
    economy?

    The international trade of the United States occurs
    predominantly with the other industrial economies.
    Exports are products sold to the rest of the world. Imports are products bought from the rest of the world.
    Exports minus imports equal net exports. Positive net
    exports mean that exports are greater than imports and
    a trade surplus exists. Negative net exports mean that
    imports exceed exports and a trade deficit exists.

    Chapter 9 / An Overview of the National and International Economies

    199

    ?

    What does government do?

    9.

    The government carries out microeconomic and macroeconomic activities. The microeconomic activities involve providing public goods and correcting market
    failures. The macroeconomic activities attempt to control the economy through monetary and fiscal policies.
    10. In the United States, monetary policy is the province
    of the Federal Reserve, and fiscal policy is up to the
    Congress and the president.
    ?

    How do the three private sectors—households,
    businesses, and the international sector—interact
    in the economy?

    12. Some household income is not spent but instead is
    saved in financial intermediaries from which firms
    borrow for expansion of their productive capacity.
    13. The circular flow diagram assumes that households
    are not directly engaged in international trade but,
    rather, that only business firms buy and sell goods and
    services across international borders.
    ?

    How does the government interact with the
    other sectors of the economy?

    14. The circular flow diagram illustrates the interaction
    among all sectors of the economy—households,
    businesses, the international sector, and the public
    sector.

    11. Money, goods, and services flow from households to
    firms and back in a circular flow.

    EXERCISES
    1.
    2.

    Is a family a household? Is a household a family?
    Which sector (household, business, or international)
    spends the most? Which sector spends the least?
    Which sector, because of volatility, has importance
    greater than is warranted by its size?
    What does it mean if net exports are negative?
    Why does the value of output always equal the income received by the resources that produced the
    output?
    Total spending in the economy is equal to consumption plus investment plus government spending plus
    net exports. If households want to save and thus do
    not use all of their income for consumption, what will
    happen to total spending? Because total spending in
    the economy is equal to total income and output, what
    will happen to the output of goods and services if
    households want to save more?
    People sometimes argue that imports should be limited by government policy. Suppose a government
    quota on the quantity of imports causes net exports to
    rise. Using the circular flow diagram as a guide, explain why total expenditures and national output may

    3.
    4.

    5.

    6.

    Internet
    Exercise

    rise after the quota is imposed. Who is likely to benefit from the quota? Who will be hurt?
    7. Draw the circular flow diagram linking households,
    business firms, and the international sector. Use the
    diagram to explain the effects of a decision by the
    household sector to increase saving.
    8. Suppose there are three countries in the world. Country A exports $11 million worth of goods to country B
    and $5 million worth of goods to country C; country
    B exports $3 million worth of goods to country A and
    $6 million worth of goods to country C; and country
    C exports $4 million worth of goods to country A and
    $1 million worth of goods to country B.
    a. What are the net exports of countries A, B, and C?
    b. Which country is running a trade deficit? A trade
    surplus?
    9. The chapter provides data indicating that there are
    many more sole proprietorships than corporations or
    partnerships. Why are there so many sole proprietorships? Why is the revenue of the average sole proprietorship less than that of the typical corporation?
    10. Using the circular flow diagram, illustrate the effects of
    an increase in taxes imposed on the household sector.

    One of the most important questions posed in Chapter 9 is “What does government do?” Use the Internet to explore an array of government agencies and their
    roles and missions.
    Go to the Boyes/Melvin Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise link
    for Chapter 9. Now answer the questions found on the Boyes/Melvin website.

    200

    Part Three / The National and Global Economies

    Study Guide for Chapter 9
    Key Term Match

    Quick-Check Quiz

    Match each key term with its correct definition by
    placing the appropriate letter next to the corresponding numbers.

    1

    Householders
    the largest median annual income.
    ■ a. 15 to 24
    ■ b. 25 to 34
    ■ c. 45 to 54
    ■ d. 55 to 64
    ■ e. over 64

    2

    Household

    A.
    B.
    C.
    D.
    E.
    F.
    G.
    H.
    I.
    J.

    household
    consumption
    multinational business
    investment
    imports
    exports
    trade surplus
    trade deficit
    net exports
    monetary policy

    K.
    L.
    M.
    N.
    O.
    P.
    Q.
    R.

    Federal Reserve
    fiscal policy
    transfer payments
    budget surplus
    budget deficit
    private sector
    public sector
    circular flow
    diagram

    1. spending on capital goods to be used in producing goods and services
    2. products that a country buys from other
    countries
    3. the shortage that results when government spending is greater than revenue
    4. the situation that exists when imports exceed
    exports
    5. policy directed toward government spending and
    taxation
    6. a firm that owns and operates producing units in
    foreign countries
    7. the excess that results when government spending is less than revenue
    8. the situation that exists when imports are less
    than exports
    9. income transferred from one citizen who is
    earning income to another citizen who may
    not be
    10. the difference between the value of exports and
    the value of imports
    11. a model showing the flow of output and income
    from one sector of the economy to another
    12. one or more persons who occupy a unit of
    housing
    13. households, businesses, and the international
    sector
    14. household spending
    15. the central bank of the United States
    16. the government
    17. products that a country sells to other countries
    18. policy directed toward the control of money and
    credit

    spending,

    or

    years old have

    consumption,

    is

    the

    component of total spending
    in the economy.
    ■ a. largest
    ■ b. second largest
    ■ c. third largest
    ■ d. fourth largest
    ■ e. smallest
    3

    Which of the following is not a component of household spending?
    ■ a. capital goods
    ■ b. housing
    ■ c. transportation
    ■ d. food
    ■ e. entertainment

    4

    In
    the owner(s) of the business is (are) responsible for all the debts incurred by
    the business and may have to pay those debts from
    his/her (their) personal wealth.

    ■ a. a sole proprietorship
    ■ b. a partnership
    ■ c. a corporation
    ■ d. sole proprietorships and partnerships
    ■ e. sole proprietorships, partnerships, and corporations
    5

    are the most common form
    of business organization, but
    account for the largest share of total revenues.
    ■ a. Sole proprietorships; partnerships
    ■ b. Sole proprietorships; corporations
    ■ c. Partnerships; corporations
    ■ d. Corporations; sole proprietorships
    ■ e. Partnerships; sole proprietorships

    6

    U.S. trade is concentrated with
    ■ a. major industrial powers.
    ■ b. developing countries.

    Chapter 9 / An Overview of the National and International Economies

    201

    ■ c. Canada and Mexico.
    ■ d. oil exporters.
    ■ e. a and c.
    7

    8

    Low-income countries are concentrated heavily in
    ■ a. Central America.
    ■ b. South America.
    ■ c. North America.
    ■ d. Africa.
    ■ e. Western Europe.

    account for the largest percentage of business revenue.

    4

    The
    is an international organization that makes loans to developing countries.

    5

    6

    7

    .

    net exports signal a

    The World Bank groups countries according to
    .

    Which of the following is a macroeconomic function
    of government?
    ■ a. provision of military protection
    ■ b. promotion of competition
    ■ c. determining the level of government spending
    and taxation
    ■ d. provision of police protection
    ■ e. correction of pollution problems

    10 The

    net exports signal a trade
    surplus;
    trade deficit.

    but

    smaller than
    ■ a. consumption; net exports
    ■ b. consumption; investment
    ■ c. net exports; investment
    ■ d. investment; net exports
    ■ e. investment; consumption

    equal exports minus imports.

    Combined government spending on goods and services is larger than

    9

    3

    8

    List three microeconomic functions of government.

    9

    What is the purpose of the circular flow diagram?

    10 The circular flow diagram shows that the value of

    is (are) responsible for

    fiscal policy, and the
    responsible for monetary policy.
    ■ a. Federal Reserve; Congress
    ■ b. Federal Reserve; Congress and the
    president
    ■ c. Congress; Federal Reserve
    ■ d. Congress and the president; Federal
    Reserve
    ■ e. Congress; Federal Reserve and the
    president

    is equal to income.

    is (are)

    Exercises and Applications
    The Circular Flow Diagram Use the following diagram to see if you understand how the three sectors of the
    economy are linked together. In the blanks below and on
    the following page, fill in the appropriate labels. Money
    flows are represented by gold and orange lines. Flows of
    physical goods and services are represented by blue and
    purple lines.

    a.

    Practice Questions and Problems

    b.

    1

    The largest component of total spending in the econ-

    c.

    omy is

    d.

    2

    202

    spending.

    is the expenditure by business firms for capital goods.

    e.
    f.

    Part Three / The National and Global Economies

    Financial
    Intermediaries

    a

    b

    c
    d

    e
    Households

    f

    i
    j
    Government

    Firms

    g

    k

    h

    l

    m
    n

    o
    Foreign Countries
    p

    g.

    o.

    h.

    p.

    i.
    j.

    l.
    m.
    n.



    ACE s

    k.

    -test
    elf



    Chapter 9 / An Overview of the National and International Economies

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    203

    Chapter 10

    ?

    Fundamental
    Questions

    1. How is the total
    output of an
    economy measured?
    2. What is the
    difference between
    nominal and real
    GDP?
    3. What is the purpose
    of a price index?
    4. How is money traded
    internationally?
    5. How do nations
    record their
    transactions with the
    rest of the world?

    Macroeconomic Measures

    J

    ust as we use degrees of temperature on a thermometer as a measure of a person’s health, we
    must use economic data to analyze the health
    of an economy. Since we prefer more goods and services to less, we need a good
    way to measure how much is produced to see if the economy is providing more
    goods and services over time and, if so, how much more. Since we like prices to
    rise slower rather than faster, we need a good way to monitor how prices change in
    the economy. Since we trade goods, services, and money with the rest of the world,
    we need good measures of how much is traded and what things cost. In this chapter, we will learn how economists measure things like output and inflation. We will
    also find out how trade with the rest of the world is counted. This will allow a solid
    foundation on which future chapters will build as we use this information in further
    analysis of business conditions both at home and abroad. ■

    Preview

    1. MEASURES OF OUTPUT AND INCOME
    national income accounting:
    the framework that
    summarizes and categorizes
    productive activity in an
    economy over a specific
    period of time, typically a year

    ?
    1. How is the total
    output of an economy
    measured?

    204

    In this chapter we discuss gross domestic product, real GDP, and other measures of
    national productive activity by making use of the national income accounting system used by all countries. National income accounting provides a framework for
    discussing macroeconomics. It measures the output of an entire economy as well as
    the flows between sectors. It summarizes the level of production in an economy
    over a specific period of time, typically a year. In practice, the process estimates the
    amount of activity that occurs. It is beyond the capability of government officials to
    count every transaction that takes place in a modern economy. Still, national
    income accounting generates useful and fairly accurate measures of economic activity in most countries, especially wealthy industrial countries that have comprehensive accounting systems.

    1.a. Gross Domestic Product
    Modern economies produce an amazing variety of goods and services. To measure
    an economy’s total production, economists combine the quantities of oranges, golf
    balls, automobiles, and all the other goods and services produced into a single measure of output. Of course, simply adding up the number of things produced—the
    number of oranges, golf balls, and automobiles—does not reveal the value of what
    is being produced. If a nation produces 1 million more oranges and 1 million fewer

    Part Three / The National and Global Economies

    The Value of Homemaker Services

    O

    ne way GDP underestimates
    the total value of a nation’s
    output is by failing to record
    nonmarket production. A prime example is the work homemakers do.
    Of course, people are not paid for
    their work around the house, so it is
    difficult to measure the value of
    their output. But notice that we say
    difficult, not impossible. Economists
    can use several methods to assign
    value to homemaker services.
    One is an opportunity cost approach. This approach measures the
    value of a homemaker’s services by
    the forgone market salary the home-

    gross domestic product
    (GDP): the market value of
    all final goods and services
    produced in a year within a
    country

    maker could have earned if he or
    she worked full-time outside the
    home. The rationale is that society
    loses the output the homemaker
    would have produced in the market
    job in order to gain the output the
    homemaker produces in the home.
    Another alternative is to estimate
    what it would cost to hire workers to
    produce the goods and services that
    the homemaker produces. For example, what would it cost to hire
    someone to prepare meals, iron,
    clean, and take care of the household? It has been estimated that the
    average homemaker spends almost

    Economic Insight
    8 hours a day, 7 days a week, on
    household work. This amounts to
    over 50 hours a week. At a rate of
    $10 an hour, the value of the homemaker’s services is over $500 a
    week.
    Whichever method we use, two
    things are clear. The value of homemaker services to the household
    and the economy is substantial. And
    by failing to account for those services, the GDP substantially underestimates the value of the nation’s
    output.

    automobiles this year than it did last year, the total number of things produced remains the same. But because automobiles are much more valuable than oranges, the
    value of output has dropped substantially. Prices reflect the value of goods and services in the market, so economists use the money value of things to create a measure
    of total output, a measure that is more meaningful than the sum of units produced.
    The most common measure of a nation’s output is gross domestic product.
    Gross domestic product (GDP) is the market value of all final goods and services
    produced in a year within a country’s borders. A closer look at three parts of this
    definition—market value, final goods and services, and produced in a year—will
    make clear what the GDP does and does not include.
    Market Value The market value of final goods and services is their value at market price. The process of determining market value is straightforward when prices
    are known and transactions are observable. However, there are cases when prices
    are not known and transactions are not observable. For instance, illegal drug transactions are not reported to the government; this means they are not included in
    GDP statistics. In fact, almost any activity that is not traded in a market is not
    included. For example, production that takes place in households, such as homemakers’ services (as discussed in the Economic Insight “The Value of Homemaker
    Services”), is not counted, nor are unreported barter and cash transactions. For instance, if a lawyer has a sick dog and a veterinarian needs some legal advice, by
    trading services and not reporting the activity to the tax authorities, each can avoid
    taxation on the income that would have been reported had they sold their services
    to each other. If the value of a transaction is not recorded as taxable income, it generally does not appear in the GDP. There are some exceptions, however. Contributions toward GDP are estimated for in-kind wages, nonmonetary compensation like
    room and board. Values of GDP also are assigned to the output consumed by a producer, for example, the home consumption of crops by a farmer.
    Final Goods and Services The second part of the definition of GDP limits the
    measure to final goods and services, the goods and services available to the ultimate
    consumer. This limitation avoids double counting. Suppose a retail store sells a shirt
    to a consumer for $20. The value of the shirt in the GDP is $20. But the shirt is made
    of cotton that has been grown by a farmer, woven at a mill, and cut and sewn by a

    Chapter 10 / Macroeconomic Measures

    205

    Figure 1

    intermediate goods: goods
    that are used as inputs in the
    production of final goods and
    services

    value added: the difference
    between the value of the
    output and the value of the
    intermediate goods used in
    the production of that output

    206

    20

    Value of Output (dollars)

    A cotton farmer sells cotton
    to a textile mill for $1, adding
    $1 to the value of the final
    shirt. The textile mill sells
    cloth to a shirt manufacturer
    for $5, adding $4 to the value
    of the final shirt. The manufacturer sells the shirt wholesale to the retail store for $12,
    adding $7 to the value of the
    final shirt. The retail store
    sells the final shirt to a consumer for $20, adding $8 to
    the value of the final shirt.
    The sum of the prices received at each stage of production equals $38, which is
    greater than the price of the
    final shirt. The sum of the
    value added at each stage of
    production equals $20, which
    equals the market value of
    the shirt.

    Final Good
    Retail Shirt

    Intermediate Goods

    $8

    Wholesale
    Shirt

    12

    $7

    7

    Cloth

    5

    $4
    1
    0
    Sum = $38
    $38

    8

    4

    Cotton
    $1
    Cotton
    Farmer

    Value Added (dollars)

    Stages of Production and
    Value Added in Shirt
    Manufacturing

    1

    Textile
    Mill

    Shirt
    Manufacturer

    Retail
    Store

    $20
    $20 = Sum

    manufacturer. What would happen if we counted the value of the shirt at each of these
    stages of the production process? We would overstate the market value of the shirt.
    Intermediate goods are goods that are used in the production of a final product.
    For instance, the ingredients for a meal are intermediate goods to a restaurant. Similarly, the cotton and the cloth are intermediate goods in the production of the shirt.
    The stages of production of the $20 shirt are shown in Figure 1. The value-of-output
    axis measures the value of the product at each stage. The cotton produced by the
    farmer sells for $1. The cloth woven by the textile mill sells for $5. The shirt manufacturer sells the shirt wholesale to the retail store for $12. The retail store sells the
    shirt—the final good—to the ultimate consumer for $20.
    Remember that GDP is based on the market value of final goods and services. In
    our example, the market value of the shirt is $20. That price already includes the
    value of the intermediate goods that were used to produce the shirt. If we add to it
    the value of output at every stage of production, we would be counting the value of
    the intermediate goods twice, and we would be overstating the GDP.
    It is possible to compute GDP by computing the value added at each stage of
    production. Value added is the difference between the value of the output and the
    value of the intermediate goods used in the production of that output. In Figure 1,
    the value added by each stage of production is listed at the right. The farmer adds
    $1 to the value of the shirt. The mill takes the cotton worth $1 and produces cloth
    worth $5, adding $4 to the value of the shirt. The manufacturer uses $5 worth of
    cloth to produce a shirt it sells for $12, so the manufacturer adds $7 to the shirt’s
    value. Finally, the retail store adds $8 to the value of the shirt: it pays the manufacturer $12 for the shirt and sells it to the consumer for $20. The sum of the value
    added at each stage of production is $20. The total value added, then, is equal to the
    market value of the final product.

    Part Three / The National and Global Economies

    Economists can compute GDP using two methods: the final goods and services
    method uses the market value of the final good or service; the value-added method
    uses the value added at each stage of production. Both methods count the value of
    intermediate goods only once. This is an important distinction: GDP is based not
    on the market value of all goods and services but on the market value of all final
    goods and services.

    inventory: the stock of unsold
    goods held by a firm

    Produced in a Year The GDP measures the value of output produced in a year.
    The value of goods produced last year is counted in last year’s GDP; the value of
    goods produced this year is counted in this year’s GDP. The year of production, not
    the year of sale, determines allocation to GDP. Although the value of last year’s
    goods is not counted in this year’s GDP, the value of services involved in the sale
    is. This year’s GDP does not include the value of a house built last year, but it does
    include the value of the real estate broker’s fee; it does not include the value of a
    used car, but it does include the income earned by the used-car dealer in the sale of
    that car.
    To determine the value of goods produced in a year but not sold in that year,
    economists calculate changes in inventory. Inventory is a firm’s stock of unsold
    goods. If a shirt that is produced this year remains on the retail store’s shelf at the
    end of the year, it increases the value of the store’s inventory. A $20 shirt increases
    that value by $20. Changes in inventory allow economists to count goods in the
    year in which they are produced whether or not they are sold.
    Changes in inventory can be planned or unplanned. A store may want a cushion
    above expected sales (planned inventory changes), or it may not be able to sell all
    the goods it expected to sell when it placed the order (unplanned inventory
    changes). For instance, suppose Jeremy owns a surfboard shop, and he always
    wants to keep 10 surfboards above what he expects to sell. This is done so that in
    case business is surprisingly good, he does not have to turn away customers to his
    competitors and lose those sales. At the beginning of the year, Jeremy has 10 surfboards and then builds as many new boards during the year as he expects to sell.
    Jeremy plans on having an inventory at the end of the year of 10 surfboards. Suppose Jeremy expects to sell 100 surfboards during the year, so he builds 100 new
    boards. If business is surprisingly poor so that Jeremy sells only 80 surfboards,
    how do we count the 20 new boards that he made but did not sell? We count the
    change in his inventory. He started the year with 10 surfboards and ends the year
    with 20 more unsold boards for a year-end inventory of 30. The change in inventory of 20 (equal to the ending inventory of 30 minus the starting inventory of 10)
    represents output that is counted in GDP. In Jeremy’s case, the inventory change is
    unplanned since he expected to sell the 20 extra surfboards that he has in his shop
    at the end of the year. But whether the inventory change is planned or unplanned,
    changes in inventory will count output that is produced but not sold in a given year.
    1.a.1. GDP as Output The GDP is a measure of the market value of a nation’s
    total output in a year. Remember that economists divide the economy into four sectors: households, businesses, government, and the international sector. The total
    value of economic activity equals the sum of the output produced in each sector.
    Since GDP counts the output produced in the United States, U.S. GDP is produced
    in business firms, households, and government located within the boundaries of the
    United States. Not unexpectedly in a capitalist country, privately owned businesses
    account for the largest percentage of output: in the United States, 77 percent of the
    GDP is produced by private firms. Government produces 11 percent of the GDP,
    and households 12 percent.
    In terms of output, GDP is the value of final goods and services produced by domestic households, businesses, and government units. If some of the firms producing in the United States are foreign owned, their output produced in the United
    States is counted in U.S. GDP.

    Chapter 10 / Macroeconomic Measures

    207

    1.a.2. GDP as Expenditures Here we look at GDP in terms of what each sector pays for goods and services it purchases. The dollar value of total expenditures—
    the sum of the amount each sector spends on final goods and services—equals the
    dollar value of output. Household spending is called consumption. Households
    spend income on goods and services to be consumed. Business spending is called
    investment. Investment is spending on capital goods that will be used to produce
    other goods and services. The two other components of total spending are government spending and net exports. Net exports are the value of exports (goods and services sold to the rest of the world) minus the value of imports (goods and services
    bought from the rest of the world).
    GDP  consumption  investment  government spending  net exports
    Or, in the shorter form commonly used by economists,
    GDP  C  I  G  X

    GDP  C  I  G  X
    where X is net exports.
    Consumption, or household spending, accounts for 70 percent of national expenditures. Government spending represents 19 percent of expenditures, and business investment 16 percent. Net exports are negative (5 percent); this means that imports exceed exports. To determine total national expenditures on domestic output,
    the value of imports, spending on foreign output, is subtracted from total
    expenditures.

    capital consumption
    allowance: the estimated
    value of depreciation plus the
    value of accidental damage to
    capital stock
    depreciation: a reduction
    in value of capital goods
    over time due to their use
    in production

    208

    1.a.3. GDP as Income The total value of output can be calculated by adding up
    the expenditures of each sector. And because one sector’s expenditures are another’s income, the total value of output also can be computed by adding up the income of all sectors.
    Business firms use factors of production to produce goods and services. The
    income earned by factors of production is classified as wages, interest, rent, and
    profits. Wages are payments to labor, including fringe benefits, social security contributions, and retirement payments. Interest is the net interest paid by businesses
    to households plus the net interest received from foreigners (the interest they pay us
    minus the interest we pay them). Rent is income earned from selling the use of real
    property (houses, shops, farms). Finally, profits are the sum of corporate profits
    plus proprietors’ income (income from sole proprietorships and partnerships).
    In terms of income, wages account for 57 percent of the GDP. Interest and profits account for 5 percent and 8 percent of the GDP, respectively. Proprietors’
    income accounts for 8 percent. Rent (1 percent) is very small in comparison. Net
    factor income from abroad is income received from U.S.-owned resources located
    in other countries minus income paid to foreign-owned resources located in the
    United States. Since U.S. GDP refers only to income earned within U.S. borders,
    we must deduct this kind of income to arrive at GDP (0.4 percent).
    The GDP also includes two income categories that we have not discussed: capital consumption allowance and indirect business taxes. Capital consumption allowance is not a money payment to a factor of production; it is the estimated value
    of capital goods used up or worn out in production plus the value of accidental
    damage to capital goods. The value of accidental damage is relatively small, so it is
    common to hear economists refer to capital consumption allowance as depreciation. Machines and other capital goods wear out over time. The reduction in the
    value of capital stock due to its being used up or worn out over time is called depreciation. A depreciating capital good loses value each year of its useful life until
    its value is zero.
    Even though capital consumption allowance does not represent income received
    by a factor of production, it must be accounted for in GDP as income. Otherwise
    the value of GDP measured as output would be higher than the value of GDP

    Part Three / The National and Global Economies

    indirect business taxes:
    taxes that are collected by
    businesses for a government
    agency

    measured as income. Depreciation is a kind of resource payment, part of the total
    payment to the owners of capital. All of the income categories—wages, interest,
    rent, profits, and capital consumption allowance—are expenses incurred in the production of output.
    Indirect business taxes, like capital consumption allowances, are not payments
    to a factor of production. They are taxes collected by businesses that then are
    turned over to the government. Both excise taxes and sales taxes are forms of indirect business taxes.
    For example, suppose a motel room in Florida costs $80 a night. A consumer
    would be charged $90. Of that $90, the motel receives $80 as the value of the service sold; the other $10 is an excise tax. The motel cannot keep the $10; it must
    turn it over to the state government. (In effect, the motel is acting as the government’s tax collector.) The consumer spends $90; the motel earns $80. To balance
    expenditures and income, we have to allocate the $10 difference to indirect business taxes.
    To summarize, GDP measured as income includes the four payments to the factors of production: wages, interest, rent, and profits. These income items represent
    expenses incurred in the production of GDP. From these we must subtract net
    factor income from abroad in order for the total to sum to GDP. Along with these
    payments are two nonincome items: capital consumption allowance and indirect
    business taxes.
    GDP  wages  interest  rent  profits  net factor income from abroad
     capital consumption allowance  indirect business taxes
    GDP is the total value of output produced in a year, the total value of expenditures made to purchase that output, and the total value of income received by the
    factors of production. Because all three are measures of the same thing—GDP—all
    must be equal.

    1.b. Other Measures of Output and Income
    GDP is the most common measure of a nation’s output, but it is not the only measure. Economists rely on a number of others in analyzing the performance of components of an economy.
    gross national product (GNP):
    gross domestic product plus
    receipts of factor income from
    the rest of the world minus
    payments of factor income to
    the rest of the world

    1.b.1. Gross National Product Gross national product (GNP) equals GDP
    plus receipts of factor income from the rest of the world minus payments of factor
    income to the rest of the world. If we add to GDP the value of income earned by
    U.S. residents from factors of production located outside the United States and subtract the value of income earned by foreign residents from factors of production
    located inside the United States, we have a measure of the value of output produced
    by U.S.-owned resources—GNP.
    Figure 2 shows the national income accounts in the United States in 2005. The
    figure begins with the GDP and then shows the calculations necessary to obtain the
    GNP and other measures of national output. In 2005, the U.S. GNP was $12,487.7
    billion.

    net national product (NNP):
    gross national product minus
    capital consumption allowance

    1.b.2. Net National Product Net national product (NNP) equals GNP
    minus capital consumption allowance. The NNP measures the value of goods and
    services produced in a year less the value of capital goods that became obsolete or
    were used up during the year. Because the NNP includes only net additions to a
    nation’s capital, it is a better measure of the expansion or contraction of current
    output than is GNP. Remember how we defined GDP in terms of expenditures in
    section 1.a.2:
    GDP  consumption  investment  government spending  net exports

    Chapter 10 / Macroeconomic Measures

    209

    Figure 2
    U.S. National Income Accounts, 2005 (billion dollars)
    Gross domestic product plus receipts of factor income
    from the rest of the world minus payments of factor
    income to the rest of the world equals gross national
    product. Gross national product minus capital consumption allowance equals net national product. Net national
    product minus indirect business taxes equals national

    income. National income plus income currently received
    but not earned (transfer payments, personal interest, dividend income) minus income currently earned but not
    received (corporate profits, net interest, social security
    taxes) equals personal income. Personal income minus
    personal taxes equals disposable personal income.

    + Receipts of factor income from the rest of the world $513.3
    – Payments of factor income to the rest of the world $ 481.5
    + Income currently
    received but not earned
    – Income currently
    earned but not received

    $31.8 $12,487.7
    $12,455.8

    Capital
    Consumption
    Allowance
    $1,604.8
    $10,882.9

    Statistical
    Discrepancy
    $71.0
    $10,811.8

    $572.6
    $10,239.2

    Personal
    Taxes
    $2,134.6
    $8,104.6

    Gross
    Domestic
    Product (GDP)

    Gross
    Net
    National
    National
    Product (GNP) Product (NNP)

    National
    Income
    (NI)

    Personal
    Income
    (PI)

    Disposable
    Personal Income
    (DPI)

    Source: Bureau of Economic Analysis, http://www.bea.gov/.

    gross investment: total
    investment, including
    investment expenditures
    required to replace capital
    goods consumed in
    current production
    net investment: gross
    investment minus capital
    consumption allowance

    national income (NI):
    net national product minus
    indirect business taxes

    210

    The investment measure in GDP (and GNP) is called gross investment. Gross
    investment is total investment, which includes investment expenditures required to
    replace capital goods consumed in current production. The NNP does not include
    investment expenditures required to replace worn-out capital goods; it includes
    only net investment. Net investment is equal to gross investment minus capital
    consumption allowance. Net investment measures business spending over and
    above that required to replace worn-out capital goods.
    Figure 2 shows that in 2005, the U.S. NNP was $10,882.9 billion. This means that
    the U.S. economy produced well over $10 trillion worth of goods and services above
    those required to replace capital stock that had depreciated. Over $1,604 billion
    in capital was “worn out” in 2005.
    1.b.3. National Income National income (NI) equals the NNP minus statistical discrepancy. The statistical discrepancy captures small adjustments from NNP

    Part Three / The National and Global Economies

    All final goods and services
    produced in a year are counted
    in GDP. For instance, the value
    of a vacation trip to the Grand
    Canyon would count as part
    of the national output of the
    United States. This would
    include the cost of lodging,
    transportation, and expenditures on food and activities.

    that do not represent incomes earned in production. NI captures the costs of the
    factors of production used in producing output.
    personal income (PI):
    national income plus income
    currently received but not
    earned, minus income
    currently earned but not
    received

    1.b.4. Personal Income Personal income (PI) is national income adjusted
    for income that is received but not earned in the current year and income
    that is earned but not received in the current year. Social Security and welfare
    benefits are examples of income that is received but not earned in the current
    year. As you learned in Chapter 9, they are called transfer payments. An example
    of income that is currently earned but not received is profits that are retained by a
    corporation to finance current needs rather than paid out to stockholders. Another
    is social security (FICA) taxes, which are deducted from workers’ paychecks.

    disposable personal income
    (DPI): personal income minus
    personal taxes

    1.b.5. Disposable Personal Income Disposable personal income (DPI)
    equals personal income minus personal taxes—income taxes, excise and real estate
    taxes on personal property, and other personal taxes. The DPI is the income that individuals have at their disposal for spending or saving. The sum of consumption
    spending plus saving must equal disposable personal income.

    R E C A P

    1. Gross domestic product (GDP) is the market value of all final goods and services produced in an economy in a year.
    2. GDP can be calculated by summing the market value of all final goods and
    services produced in a year, by summing the value added at each stage of
    production, by adding total expenditures on goods and services (GDP  consumption  investment  government spending  net exports), and by using
    the total income earned in the production of goods and services (GDP 
    wages  interest  rent  profits), subtracting net factor income from
    abroad, and adding depreciation and indirect business taxes.

    Chapter 10 / Macroeconomic Measures

    211

    Now You Try It
    Use the following information
    to find the value of:
    a. GDP
    d. NI
    b. GNP
    e. PI
    c. NNP
    f. DPI
    Consumption
    Gross investment
    Government spending
    Net exports
    Income earned
    but not received
    Income received
    but not earned
    Personal taxes
    Capital consumption
    allowance
    Receipts of factor
    income from the
    rest of the world
    Payments of factor
    income to the rest
    of the world
    Indirect business
    taxes

    $600
    $100
    $200
    $100
    $ 20
    $ 30
    $200
    $230

    $ 50

    $ 50

    3. Other measures of output and income include gross national product (GNP),
    net national product (NNP), national income (NI), personal income (PI), and
    disposable personal income (DPI).
    National Income Accounts
    GDP  consumption  investment  government spending
     net exports
    GNP  GDP  receipts of factor income from the rest of the world
     payments of factor income to the rest of the world
    NNP  GNP  capital consumption allowance
    NI  NNP  statistical discrepancy
    PI  NI  income earned but not received
     income received but not earned
    DPI  PI  personal taxes

    2. NOMINAL AND REAL MEASURES
    The GDP is the market value of all final goods and services produced within a
    country in a year. Value is measured in money terms, so the U.S. GDP is reported in dollars, the German GDP in euros, the Mexican GDP in pesos, and so
    on. Market value is the product of two elements: the money price and the quantity produced.

    $ 90

    2.a. Nominal and Real GDP
    nominal GDP: a measure of
    national output based on the
    current prices of goods and
    services
    real GDP: a measure of the
    quantity of final goods and
    services produced, obtained
    by eliminating the influence
    of price changes from the
    nominal GDP statistics

    ?
    2. What is the difference
    between nominal and
    real GDP?

    212

    Nominal GDP measures output in terms of its current dollar value. Real GDP is
    adjusted for changing price levels. In 1980, the nominal U.S. GDP was $2,796
    billion; in 2000, it was $9,872.9 billion—an increase of 250 percent. Does this
    mean that the United States produced 250 percent more goods and services in 2000
    than it did in 1980? If the numbers reported are for nominal GDP, we cannot be
    sure. Nominal GDP cannot tell us whether the economy produced more goods and
    services because nominal GDP changes when prices change and when quantity
    changes.
    Real GDP measures output in constant prices. This allows economists to identify the changes in actual production of final goods and services: real GDP measures the quantity of goods and services produced after eliminating the influence of
    price changes contained in nominal GDP. In 1980, real GDP in the United States
    was $4,901 billion; in 2000, it was $9,224 billion, an increase of 88 percent. The
    250 percent increase in nominal GDP in large part reflects increased prices, not
    increased output.
    Since we prefer more goods and services to higher prices, it is better to have
    nominal GDP rise because of higher output than because of higher prices. We want
    nominal GDP to increase as a result of an increase in real GDP.
    Consider a simple example that illustrates the difference between nominal GDP
    and real GDP. Suppose a hypothetical economy produces just three goods: oranges,
    coconuts, and pizzas. The dollar value of output in three different years is listed in
    the table in Figure 3.
    As shown in Figure 3, in year 1, 100 oranges were produced at $.50 per orange,
    300 coconuts at $1 per coconut, and 2,000 pizzas at $8 per pizza. The total dollar
    value of output in year 1 was $16,350. In year 2, prices are constant at the year 1
    values, but the quantity of each good has increased by 10 percent. The dollar value

    Part Three / The National and Global Economies

    Price

    Prices and Quantities in a
    Hypothetical Economy
    In year 1, total output was
    $16,350. In year 2, prices remained constant but quantities produced increased by
    10 percent, resulting in a
    higher output of $17,985.
    With prices constant, we can
    say that both nominal GDP
    and real GDP increased from
    year 1 to year 2. In year 3,
    quantities produced remained constant but prices
    increased by 10 percent, resulting in the same increased
    output as in year 2, $17,985.
    Production did not change
    from year 1 to year 3, however, so though nominal GDP
    increased, real GDP remained
    constant.

    Year 1
    (base year)

    +

    Figure 3

    Quantity

    .50

    100 Oranges

    1.00

    300 Coconuts

    8.00

    =

    Output

    $16,350

    2,000 Pizzas

    Nominal GDP = Real GDP

    Year 2
    (quantities
    increase 10%)

    .50

    110 Oranges

    1.00

    330 Coconuts

    8.00

    $17,985

    2,200 Pizzas

    Nominal GDP Increases
    Real GDP Increases

    Year 3
    (prices
    increase 10%)

    .55

    100 Oranges

    1.10

    300 Coconuts

    8.80

    $17,985

    2,000 Pizzas

    Nominal GDP Increases
    Real GDP Remains Constant

    of output in year 2 is $17,985, 10 percent higher than the value of output in year 1.
    In year 3, the quantity of each good is back at the year 1 level, but prices have increased by 10 percent. Oranges now cost $.55, coconuts $1.10, and pizzas $8.80.
    The dollar value of output in year 3 is $17,985.
    Notice that in years 2 and 3, the dollar value of output ($17,985) is 10 percent
    higher than it was in year 1. But there is a difference here. In year 2, the increase in
    the dollar value of output is due entirely to an increase in the production of the
    three goods. In year 3, the increase is due entirely to an increase in the prices of the
    goods.
    Because prices did not change between years 1 and 2, the increase in nominal
    GDP is entirely accounted for by an increase in real output, or real GDP. In years 1
    and 3, the actual quantities produced did not change, which means that real GDP was
    constant; only nominal GDP was higher, a product only of higher prices.

    ?
    3. What is the purpose of
    a price index?

    2.b. Price Indexes
    The total dollar value of output or income is equal to price multiplied by the quantity of goods and services produced:

    Chapter 10 / Macroeconomic Measures

    Dollar value of output  price  quantity

    213

    By dividing the dollar value of output by price, you can determine the quantity
    of goods and services produced:
    Quantity 
    price index: a measure of
    the average price level in an
    economy

    base year: the year against
    which other years are
    measured

    dollar value of output
    price

    In macroeconomics, a price index measures the average level of prices in an
    economy and shows how prices, on average, have changed. Prices of individual
    goods can rise and fall relative to one another, but a price index shows the general
    trend in prices across the economy.
    2.b.1. Base Year The example in Figure 3 provides a simple introduction to
    price indexes. The first step is to pick a base year, the year against which other
    years are measured. Any year can serve as the base year. Suppose we pick year 1
    in Figure 3. The value of the price index in year 1, the base year, is defined to be
    100. This simply means that prices in year 1 are 100 percent of prices in year 1
    (100 percent of 1 is 1). In the example, year 2 prices are equal to year 1 prices, so
    the price index also is equal to 100 in year 2. In year 3, every price has risen 10
    percent relative to the base-year (year 1) prices, so the price index is 10 percent
    higher in year 3, or 110. The value of the price index in any particular year indicates how prices have changed relative to the base year. A value of 110 indicates
    that prices are 110 percent of base-year prices, or that the average price level has
    increased 10 percent.
    Price index in any year  100 / percentage change in base-year prices

    GDP price index (GDPPI): a
    broad measure of the prices of
    goods and services included in
    the gross domestic product

    consumer price index (CPI): a
    measure of the average price of
    goods and services purchased
    by the typical household

    cost of living adjustment
    (COLA): an increase in wages
    that is designed to match
    increases in the prices of items
    purchased by the typical
    household
    producer price index (PPI):
    a measure of average prices
    received by producers

    214

    2.b.2. Types of Price Indexes The price of a single good is easy to determine. But how do economists determine a single measure of the prices of the millions of goods and services produced in an economy? They have constructed price
    indexes to measure the price level; there are several different price indexes used to
    measure the price level in any economy. Not all prices rise or fall at the same time
    or by the same amount. This is why there are several measures of the price level in
    an economy.
    The price index used to estimate constant dollar real GDP is the GDP price index (GDPPI), a measure of prices across the economy that reflects all of the categories of goods and services included in GDP. The GDPPI is a very broad measure.
    Economists use other price indexes to analyze how prices change in more specific
    categories of goods and services.
    Probably the best-known price index is the consumer price index (CPI). The
    CPI measures the average price of consumer goods and services that a typical
    household purchases. The CPI is a narrower measure than the GDPPI because it
    includes fewer items. However, because of the relevance of consumer prices to the
    standard of living, news reports on price changes in the economy typically focus
    on consumer price changes. In addition, labor contracts sometimes include provisions that raise wages as the CPI goes up. Social Security payments also are tied
    to increases in the CPI. These increases are called cost of living adjustments
    (COLAs) because they are supposed to keep nominal income rising along with
    the cost of items purchased by the typical household.
    The producer price index (PPI) measures average prices received by producers. At one time this price index was known as the wholesale price index (WPI).
    Because the PPI measures price changes at an earlier stage of production than the
    CPI, it can indicate a coming change in the CPI. If producer input costs are rising,
    we can expect the price of goods produced to go up as well.
    Figure 4 illustrates how the three different measures of prices have changed over
    time. Notice that the PPI is more volatile than the GDPPI or the CPI. This is

    Part Three / The National and Global Economies

    Figure 4

    The graph plots the annual
    percentage change in the
    GDP price index (GDPPI), the
    consumer price index (CPI),
    and the producer price index
    (PPI). The GDPPI is used to
    construct constant dollar real
    GDP. The CPI measures the
    average price of consumer
    goods and services that a typical household purchases.
    The PPI measures the average price received by producers; it is the most variable of
    the three because fluctuations in equilibrium prices of
    intermediate goods are much
    greater than for final goods.

    Annual Percentage Changes in Prices

    The GDP Price Index, the
    CPI, and the PPI

    15
    14
    13
    12
    11
    10
    9
    8
    7
    6
    5
    4
    3
    2
    1
    0
    –1
    –2

    PPI
    CPI
    GDPPI

    1960

    1965

    1970

    1975

    1980

    1985

    1990

    1995

    2000

    2005

    Year
    Source: http://www.bls.gov and http://www.bea.gov.

    because there are smaller fluctuations in the equilibrium prices of final goods than
    in those of intermediate goods.

    R E C A P

    1. Nominal GDP is measured using current dollars.
    2. Real GDP measures output with price effects removed.
    3. The GDP price index, the consumer price index, and the producer price index
    are all measures of the level of prices in an economy.

    3. FLOWS OF INCOME AND EXPENDITURES
    The GDP is both a measure of total expenditures on final goods and services and a
    measure of the total income earned in the production of those goods and services.
    The idea that total expenditures equal total income is clearly illustrated in the circular flow diagram of Chapter 9.
    The figure links the four sectors of the economy: households, firms, government,
    and foreign countries. The arrows between the sectors indicate the direction of the
    flows. The money flows are both income and expenditures. Because one sector’s expenditures represent another sector’s income, the total expenditures on goods and
    services must be the same as the total income from selling goods and services, and
    those must both be equal to the total value of the goods and services produced.

    R E C A P

    1. Total spending on final goods and services equals the total income received
    in producing those goods and services.
    2. The circular flow model shows that one sector’s expenditures represent other
    sectors’ incomes.

    Chapter 10 / Macroeconomic Measures

    215

    4. THE FOREIGN EXCHANGE MARKET
    foreign exchange: currency
    and bank deposits that are
    denominated in foreign money
    foreign exchange market: a
    global market in which people
    trade one currency for another

    ?
    4. How is money traded
    internationally?

    Foreign exchange is foreign money, including paper money and bank deposits like
    checking accounts that are denominated in foreign currency. When someone with
    U.S. dollars wants to trade those dollars for Japanese yen, the trade takes place in the
    foreign exchange market, a global market in which people trade one currency for
    another. Many financial markets are located in a specific geographic location. For
    instance, the New York Stock Exchange is a specific location in New York City where
    stocks are bought and sold. The Commodity Exchange is a specific location in New
    York City where contracts to deliver agricultural and metal commodities are bought
    and sold. The foreign exchange market is not in a single geographic location, however. Trading occurs all over the world by telephone or electronically. Most of the
    activity involves large banks in New York, London, and other financial centers. A
    foreign exchange trader at Bank of America in New York can buy or sell currencies
    with a trader at Barclays Bank in London by electronic or telephone communication.
    Only tourism and a few other transactions in the foreign exchange market involve
    the actual movement of currency. The great majority of transactions involve the buying and selling of bank deposits denominated in foreign currency. Currency notes,
    like dollar bills, are used in a relatively small fraction of transactions. When a large
    corporation or a government buys foreign currency, it buys a bank deposit denominated in the foreign currency. Still, all exchanges in the market require that monies
    have a price.

    4.a. Exchange Rates
    An exchange rate is the price of one country’s money in terms of another country’s
    money. Exchange rates are needed to compare prices quoted in two different currencies. Suppose a shirt that has been manufactured in Canada sells for 20 U.S.
    dollars in Seattle, Washington, and for 25 Canadian dollars in Vancouver, British
    Columbia. Where would you get the better buy? Unless you know the exchange
    rate between U.S. and Canadian dollars, you can’t tell. The exchange rate allows
    you to convert the foreign currency price into its domestic currency equivalent,
    which then can be compared to the domestic price.
    Table 1 lists exchange rates for February 16, 2007. The rates are quoted in U.S. dollars per unit of foreign currency in the second column, and in units of foreign currency per U.S. dollar in the last column. For instance, the Canadian dollar was selling
    for $.8593, or a little less than 86 U.S. cents. The same day, the U.S. dollar was selling for 1.1638 Canadian dollars (1 U.S. dollar would buy 1.1638 Canadian dollars).
    If you know the price in U.S. dollars of a currency, you can find the price of the
    U.S. dollar in that currency by taking the reciprocal. To find the reciprocal of a
    number, write it as a fraction and then turn the fraction upside down. Let’s say that
    1 British pound sells for 2 U.S. dollars. In fraction form, 2 is 2/1. The reciprocal of
    2/1 is 1/2, or .5. So 1 U.S. dollar sells for .5 British pounds. The table shows that
    the actual dollar price of the pound was 1.9499. The reciprocal exchange rate—the
    number of pounds per dollar—is .5128 (1/1.9499), which was the pound price of
    1 dollar that day.
    Let’s go back to comparing the price of the Canadian shirt in Seattle and
    Vancouver. The symbol for the U.S. dollar is $. The symbol for the Canadian dollar
    is C$. The shirt sells for $20 in Seattle and C$25 in Vancouver. Suppose the exchange rate between the U.S. dollar and the Canadian dollar is .8. This means that
    C$1 costs $.80.
    To find the domestic currency value of a foreign currency price, multiply the
    foreign currency price by the exchange rate:
    Domestic currency value  foreign currency price  exchange rate

    216

    Part Three / The National and Global Economies

    Table 1

    Country

    Exchange Rates
    February 16, 2007

    U.S. $ per Currency

    Currency per U.S. $

    Australia (dollar)

    0.7868

    1.2710

    Britain (pound)

    1.9499

    0.5128

    Canada (dollar)

    0.8593

    1.1638

    China (renminbi)

    0.1292

    7.7426

    European (euro)

    1.3137

    Japan (yen)

    0.0084

    0.7612
    119.23

    Mexico (peso)

    0.0910

    10.9924

    New Zealand (dollar)

    0.6975

    1.4337

    Singapore (dollar)

    0.6530

    1.5315

    Switzerland (franc)

    0.8103

    1.2341

    Source: Federal Reserve Bank of New York, http://www.newyorkfed.org/markets/fxrates.

    In our example, the U.S. dollar is the domestic currency:
    U.S. dollar value  C$25  0.8  $20
    If we multiply the price of the shirt in Canadian dollars (C$25) by the exchange
    rate (0.8), we find the U.S. dollar value ($20). After adjusting for the exchange rate,
    then, we can see that the shirt sells for the same price when the price is measured in
    a single currency.

    4.b. Exchange Rate Changes and International Trade
    Because exchange rates determine the domestic currency value of foreign goods,
    changes in those rates affect the demand for and supply of goods traded internationally. Suppose the price of the shirt in Seattle and in Vancouver remains the
    same, but the exchange rate changes from .8 to .9 U.S. dollars per Canadian dollar.
    What happens? The U.S. dollar price of the shirt in Vancouver increases. At the
    new rate, the shirt that sells for C$25 in Vancouver costs a U.S. buyer $22.50
    (C$25  0.9).
    A rise in the value of a currency is called appreciation. In our example, as the
    exchange rate moves from $.8  C$1 to $.9  C$1, the Canadian dollar appreciates against the U.S. dollar. As a country’s currency appreciates, international demand for its products falls, other things equal.
    Suppose the exchange rate in our example moves from $.8  C$1 to $.7  C$1.
    Now the shirt that sells for C$25 in Vancouver costs a U.S. buyer $17.50 (C$25 
    0.7). In this case the Canadian dollar has depreciated in value relative to the U.S.
    dollar. As a country’s currency depreciates, its goods sell for lower prices in other
    countries and the demand for its products increases, other things remaining equal.
    When the Canadian dollar is appreciating against the U.S. dollar, the U.S. dollar
    must be depreciating against the Canadian dollar. For instance, when the exchange
    rate between the U.S. dollar and the Canadian dollar moves from $.8  C$1 to
    $.9  C$1, the reciprocal exchange rate—the rate between the Canadian dollar and
    the U.S. dollar—moves from C$1.25  $1 (1/.8  1.25) to C$1.11  $1 (1/0.9 
    1.11). At the same time that Canadian goods are becoming more expensive to U.S.
    buyers, U.S. goods are becoming cheaper to Canadian buyers.

    Chapter 10 / Macroeconomic Measures

    217

    R E C A P

    ?
    5. How do nations record
    their transactions with
    the rest of the world?

    balance of payments: a
    record of a country’s trade in
    goods, services, and financial
    assets with the rest of the
    world

    1. The foreign exchange market is a global market in which currencies of different countries, largely bank deposits, are bought and sold.
    2. An exchange rate is the price of one country’s money in terms of another’s.
    3. Foreign demand for domestic goods decreases as the domestic currency appreciates and increases as the domestic currency depreciates.

    5. THE BALANCE OF PAYMENTS
    The U.S. economy does not operate in a vacuum. It affects and is affected by the
    economies of other nations. This point was brought home to Americans in
    recent years as newspaper headlines announced the latest trade deficit, and politicians denounced foreign countries for running trade surpluses against the United
    States. It seemed as if everywhere there was talk of the balance of payments.
    The balance of payments is a record of a country’s trade in goods, services, and
    financial assets with the rest of the world. This record is divided into categories, or
    accounts, that summarize the nation’s international economic transactions. For example, one category measures transactions in merchandise; another measures
    transactions involving financial assets (bank deposits, bonds, stocks, loans). These
    accounts distinguish between private transactions (by individuals and businesses)
    and official transactions (by governments). Balance of payments data are reported
    quarterly for most developed countries.

    5.a. Balance of Payments Accounts
    current account: the sum
    of the merchandise, services,
    investment income, and
    unilateral transfers accounts in
    the balance of payments

    balance of trade: the balance
    on the merchandise account in
    a nation’s balance of payments

    The balance of payments uses several different accounts to classify transactions
    (Table 2). The current account is the sum of the balances in the merchandise, services, investment income, and unilateral transfers accounts.
    Merchandise This account records all transactions involving goods. U.S. exports
    of goods bring money into the country for U.S. exporters. U.S. imports of foreign
    goods require payments to foreign sellers. When exports exceed imports, the
    merchandise account shows a surplus. When imports exceed exports, the account
    shows a deficit. The balance on the merchandise account is frequently referred to
    as the balance of trade.

    Table 2

    Account

    Net Balance

    Simplified U.S. Balance of
    Payments, 2005 (millions of
    dollars)

    Merchandise

    $  782,740

    Services

    $

    Investment income

    $

    11,293

    Unilateral transfers

    $

     86,072

    Current account

    $  791,508

    Financial account

    $

    801,918

    Statistical discrepancy

    $

    10,410

    66,011

    Source: Data from Bureau of Economic Analysis,
    http://www.bea.gov.

    218

    Part Three / The National and Global Economies

    The introduction of the euro
    in Western Europe is the most
    important event in international
    finance since the end of World
    War II. Now business is conducted in the same currency regardless of whether you are in
    Greece or Germany or any of the
    other countries that have discarded their national currencies
    and adopted the euro.

    In 2005, the merchandise account in the U.S. balance of payments showed a
    deficit of $782,740 million. In other words, the United States bought more goods
    from other nations than it sold to them.
    Services This account measures trade involving services. It includes travel and
    tourism, royalties, transportation costs, and insurance premiums. In 2005, the
    balance on the services account was a $66,011 million surplus.
    Investment Income The income earned from investments in foreign countries
    brings money into the United States; the income paid on foreign-owned investments
    in the United States takes money out of the United States. Investment income is
    the return on a special kind of service: it is the value of services provided by
    capital in foreign countries. In 2005, there was a surplus of $11,293 million in the
    investment income account.

    financial account: the record
    in the balance of payments of
    the flow of financial assets into
    and out of a country

    Unilateral Transfers In a unilateral transfer, one party gives something but gets
    nothing in return. Gifts and retirement pensions are forms of unilateral transfers.
    For instance, if a farmworker in El Centro, California, sends money to his family
    in Guaymas, Mexico, this is a unilateral transfer from the United States to Mexico.
    In 2005, that unilateral transfers balance was a deficit of $86,072.
    The current account is a useful measure of international transactions because it
    contains all of the activities involving goods and services. The financial account is
    where trade involving financial assets and international investment is recorded. In
    2005, the current account showed a deficit of $791,508 million. This means that
    U.S. imports of merchandise, services, investment income, and unilateral transfers
    were $791,508 million greater than exports of these items.
    If we draw a line in the balance of payments under the current account, then all entries below the line relate to financing the movement of merchandise, services, investment income, and unilateral transfers into and out of the country. Financial account
    transactions include bank deposits, purchases of stocks and bonds, loans, land purchases, and purchases of business firms. Inflows of money associated with the U.S.
    financial account reflect foreign purchases of U.S. financial assets or real property
    like land and buildings, and outflows of money reflect U.S. purchases of foreign financial assets and real property. In 2005, the U.S. financial account showed a surplus
    of $801,918 million.

    Chapter 10 / Macroeconomic Measures

    219

    The statistical discrepancy account, the last account listed in Table 2, could be
    called omissions and errors. Government cannot accurately measure all transactions
    that take place. Some international shipments of goods and services go uncounted or
    are miscounted, as are some international flows of capital. The statistical discrepancy
    account is used to correct for these omissions and errors. In 2005, measured deficits
    exceeded measured surpluses, so the statistical discrepancy was $10,410 million.
    Over all of the balance of payments accounts, the sum of surplus accounts must
    equal the sum of deficit accounts. The bottom line—the net balance—must be
    zero. It cannot show a surplus or a deficit. When people talk about a surplus or a
    deficit in the balance of payments, they actually are talking about a surplus or a
    deficit in one of the balance of payments accounts. The balance of payments itself,
    by definition, is always in balance.

    5.b. The Current Account and the Financial Account
    The current account reflects the movement of goods and services into and out of a
    country. The financial account reflects the flow of financial assets into and out of a
    country. In Table 2, the current account shows a deficit balance of $791,508 million.
    Remember that the balance of payments must balance. If there is a deficit in the current account, there must be a surplus in the financial account that offsets that deficit.
    What is important here is not the bookkeeping process, the concept that the balance of payments must balance, but rather the meaning of deficits and surpluses in
    the current and financial accounts. These deficits and surpluses tell us whether
    a country is a net borrower from or lender to the rest of the world. A deficit in the
    current account means that a country is running a net surplus in its financial account. And it signals that a country is a net borrower from the rest of the world.
    A country that is running a current account deficit must borrow from abroad an
    amount sufficient to finance that deficit. A financial account surplus is achieved by

    Figure 5

    50

    The U.S. Current Account
    Balance

    Source: Bureau of Economic
    Analysis.

    Balance on Current Account (billions of dollars)

    The current account of the
    balance of payments is the
    sum of the balances in the
    merchandise, services, investment income, and unilateral
    transfers accounts. The
    United States experienced
    very large current account
    deficits in the 1980s and
    again more recently.

    0
    –50
    –100
    –150
    –200
    –250
    –300
    –350
    –400
    –450
    –500
    –550
    –600
    –650
    –700

    1960

    1965

    1970

    1975

    1980

    1985

    1990

    1995

    2000

    2005

    Year

    220

    Part Three / The National and Global Economies

    selling more bonds and other debts of the domestic country to the rest of the world
    than the country buys from the rest of the world.
    Figure 5 shows the current account balance in the United States. The United States
    experienced large current account deficits in the 1980s and then again in the late
    1990s and 2000s. Such deficits indicate that the United States consumed more than it
    produced. Remember that in section 1.a.2 of this chapter, GDP is equal to total
    expenditures, or GDP  C  I  G  X, where X is net exports. A country with a
    current account deficit will have negative net exports. Rewriting the total spending
    equation as X  GDP  C  I  G, a negative X means that domestic spending,
    C  I  G, must be greater than domestic production, GDP. This means that the
    United States sold financial assets and borrowed large amounts of money from foreign residents to finance its current account deficits. This large foreign borrowing
    made the United States the largest debtor in the world. A net debtor owes more to the
    rest of the world than it is owed; a net creditor is owed more than it owes. The United
    States was an international net creditor from the end of World War I until the mid1980s. The country financed its large current account deficits in the 1980s by borrowing from the rest of the world. As a result of this accumulated borrowing, in 1985 the
    United States became an international net debtor for the first time in almost 70 years.
    Since that time, the net debtor status of the United States has grown steadily.

    R E C A P

    1. The balance of payments is a record of a nation’s international transactions.
    2. The current account is the sum of the balances in the merchandise, services,
    investment income, and unilateral transfers accounts.
    3. A surplus exists when money inflows exceed outflows; a deficit exists when
    money inflows are less than outflows.
    4. The financial account is where the transactions necessary to finance the
    movement of merchandise, services, investment income, and unilateral transfers into and out of the country are recorded.
    5. The net balance in the balance of payments must be zero.
    6. A deficit in the current account must be offset by a surplus in the financial account. It also indicates that the nation is a net borrower.

    SUMMARY
    ?

    1.

    2.
    3.
    4.

    5.

    How is the total output of an economy
    measured?

    National income accounting is the system economists
    use to measure both the output of an economy and the
    flows between sectors of that economy.
    Gross domestic product (GDP) is the market value of all
    final goods and services produced in a year in a country.
    The GDP also equals the value added at each stage of
    production.
    The GDP as output equals the sum of the output of
    households, business firms, and government within
    the country.
    The GDP as expenditures equals the sum of consumption plus investment plus government spending plus
    net exports.

    Chapter 10 / Macroeconomic Measures

    6.

    The GDP as income equals the sum of wages, interest,
    rent, profits, proprietors’ income, capital consumption
    allowance, and indirect business taxes less net factor
    income from abroad.

    7.

    Other measures of national output include gross national product (GNP), net national product (NNP), national income (NI), personal income (PI), and disposable personal income (DPI).

    ?

    8.

    What is the difference between nominal and
    real GDP?

    Nominal GDP measures output in terms of its current
    dollar values including the effects of price changes;
    real GDP measures output after eliminating the effects
    of price changes.

    221

    ?

    What is the purpose of a price index?

    9.

    A price index measures the average level of prices
    across an economy.
    10. Total expenditures on final goods and services equal
    total income.
    ?

    How is money traded internationally?

    11. Foreign exchange is currency and bank deposits that
    are denominated in foreign currency.
    12. The foreign exchange market is a global market in
    which people trade one currency for another.
    13. Exchange rates, the price of one country’s money in
    terms of another country’s money, are necessary to
    compare prices quoted in different currencies.
    14. The value of a good in a domestic currency equals the
    foreign currency price times the exchange rate.
    15. When a domestic currency appreciates, domestic
    goods become more expensive to foreigners, and foreign goods become cheaper to domestic residents.

    16. When a domestic currency depreciates, domestic
    goods become cheaper to foreigners, and foreign
    goods become more expensive to domestic residents.
    ?

    How do nations record their transactions with
    the rest of the world?

    17. The balance of payments is a record of a nation’s
    transactions with the rest of the world.
    18. The current account is the sum of the balances in the
    merchandise, services, investment income, and unilateral transfers accounts.
    19. The financial account reflects the transactions necessary to finance the movement of merchandise, services, investment income, and unilateral transfers into
    and out of the country.
    20. A deficit in the current account must be offset by a
    surplus in the financial account.

    EXERCISES
    1.

    The following table lists the stages required in the
    production of a personal computer. What is the value
    of the computer in the GDP?
    Stage
    Components manufacture
    Assembly
    Wholesaler
    Retailer

    2.

    Value Added
    $

    50
    250
    500
    1,500

    What is the difference between GDP and each of the
    following?
    a. gross national product
    b. net national product
    c. national income
    d. personal income
    e. disposable personal income

    Use the following national income accounting information to do exercises 3–7:
    Consumption
    Imports
    Net investment
    Government purchases
    Exports
    Capital consumption allowance
    Statistical discrepancy
    Receipts of factor income from the rest
    of the world
    Payments of factor income to the rest of
    the world

    222

    $400
    10
    20
    100
    20
    20
    5
    12
    10

    3.
    4.
    5.
    6.
    7.
    8.

    What is the GDP for this economy?
    What is the GNP for this economy?
    What is the NNP for this economy?
    What is the national income for this economy?
    What is the gross investment in this economy?
    Why has nominal GDP increased faster than real GDP
    in the United States over time? What would it mean if
    an economy had real GDP increasing faster than nominal GDP?
    9. If a surfboard is produced this year but not sold until
    next year, how is it counted in this year’s GDP and not
    next year’s?
    10. What is the price of 1 U.S. dollar in terms of each
    of the following currencies, given the following exchange rates?
    a. 1 European euro  $.95
    b. 1 Chinese yuan  $.12
    c. 1 Israeli shekel  $.30
    d. 1 Kuwaiti dinar  $3.20
    11. A bicycle manufactured in the United States costs
    $100. Using the exchange rates listed in Table 1, what
    would the bicycle cost in the currency of each of the
    following countries?
    a. Australia
    b. Britain
    c. Canada
    12. The U.S. dollar price of a Swedish krona changes
    from $.1572 to $.1730.

    Part Three / The National and Global Economies

    a. Has the dollar depreciated or appreciated against
    the krona?
    b. Has the krona appreciated or depreciated against
    the dollar?
    Use the information in the following table on Mexico’s international transactions to do exercises 13–15 (the amounts
    are the U.S. dollar values in millions):
    Merchandise imports
    Merchandise exports
    Services exports
    Services imports
    Investment income receipts
    Investment income payments
    Unilateral transfers
    13. What is the balance of trade?
    14. What is the current account?

    Internet
    Exercise

    $96,000
    89,469
    10,901
    10,819
    4,032
    17,099
    4,531

    15. Did Mexico become a larger international net debtor
    during this period?
    16. If the U.S. dollar appreciated against the euro, what
    would you expect to happen to U.S. net exports with
    Germany?
    17. Suppose the U.S. dollar price of a British pound is
    $1.50; the dollar price of a euro is $.90; a hotel room
    in London, England, costs 120 British pounds; and a
    comparable hotel room in Hanover, Germany, costs
    220 euros.
    a. Which hotel room is cheaper to a U.S. tourist?
    b. What is the exchange rate between the euro and the
    British pound?
    18. Use the national income accounting definition GDP 
    C  I  G  X to explain what a current account
    deficit (negative net exports) means in terms of domestic spending, production, and borrowing.

    Use the Internet to explore why the CPI doesn’t always match an individual’s
    experience with inflation, and to learn about the United Nations’ Human Development Index.
    Go to the Boyes/Melvin Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise link
    for Chapter 10. Now answer the questions found on the Boyes/Melvin website.

    Chapter 10 / Macroeconomic Measures

    223

    Study Guide for Chapter 10
    Key Term Match

    12. a measure of the average price of goods and services purchased by the typical household
    13. gross national product minus capital consumption
    allowance
    14. a global market in which people trade one currency for another
    15. a measure of national output based on the current
    prices of goods and services
    16. total investment, including investment expenditures required to replace capital goods consumed
    in current production
    17. the balance on the merchandise account in a nation’s balance of payments
    18. a record of a country’s trade in goods, services,
    and financial assets with the rest of the world
    19. net national product minus indirect business taxes
    20. the year against which other years are measured
    21. the framework that summarizes and categorizes
    productive activity in an economy over a specific
    period of time, typically a year
    22. an increase in wages that is designed to match increases in the prices of items purchased by the
    typical household
    23. the estimated value of depreciation plus the value
    of accidental damage to capital stock
    24. the record in the balance of payments of the flow
    of financial assets into and out of a country
    25. goods that are used as inputs in the production of
    final goods and services
    26. gross investment minus capital consumption
    allowance
    27. personal income minus personal taxes
    28. a broad measure of the prices of goods and services included in the gross domestic product
    29. a measure of average prices received by producers

    Match each term with its correct definition by placing
    the appropriate letter next to the corresponding number.
    A. national income
    accounting
    B. gross domestic
    product (GDP)
    C. intermediate goods
    D. value added
    E. inventory
    F. capital consumption
    allowance
    G. depreciation
    H. indirect business
    taxes
    I. gross national
    product (GNP)
    J. net national
    product (NNP)
    K. gross investment
    L. net investment
    M. national income
    N. personal income

    O. disposable
    personal income
    P. nominal GDP
    Q. real GDP
    R. price index
    S. base year
    T. GDP price index
    U. consumer price
    index
    V. cost of living
    adjustment
    W. producer price index
    X. foreign exchange
    Y. foreign exchange
    market
    Z. balance of payments
    AA. current account
    BB. balance of trade
    CC. financial account

    1. the difference between the value of the output and
    the value of the intermediate goods used in the
    production of that output
    2. taxes that are collected by businesses for a government agency
    3. a measure of the average price level in an economy
    4. the stock of unsold goods held by a firm
    5. national income plus income currently received
    but not earned, minus income currently earned but
    not received
    6. a reduction in value of capital goods over time due
    to their use in production
    7. gross domestic product plus receipts of factor income from the rest of the world minus payments
    of factor income to the rest of the world
    8. currency and bank deposits that are denominated
    in foreign money
    9. the sum of the merchandise, services, investment
    income, and unilateral transfers accounts in the
    balance of payments
    10. the market value of all final goods and services
    produced in a year within a country
    11. a measure of the quantity of final goods and
    services produced, obtained by eliminating the
    influence of price changes from the nominal
    GDP statistics

    224

    Quick-Check Quiz
    1

    Which of the following is counted in GDP?
    ■ a. the value of homemaker services
    ■ b. estimated illegal drug transactions
    ■ c. the value of oil used in the production of gasoline
    ■ d. estimated in-kind wages
    ■ e. the sale of a used automatic dishwasher

    2

    A price index equal to 90 in a given year
    ■ a. indicates that prices were lower than prices in
    the base year.
    ■ b. indicates that the year in question was a year
    previous to the base year.

    Part Three / The National and Global Economies

    ■ d. is a net borrower from the rest of the world.
    ■ e. is running a surplus in its merchandise account.

    ■ c. indicates that prices were 10 percent higher than
    prices in the base year.
    ■ d. is inaccurate—price indexes cannot be lower
    than 100.
    ■ e. indicates that real GDP was lower than GDP in
    the base year.
    3

    4

    6

    7

    ■ b. Swiss goods are now
    (more expensive, cheaper) in the United States.

    ■ c. As a result of the change in exchange rates, U.S.

    exports to Switzerland will
    (increase, decrease), all other things being equal.
    10 You read in the paper that the Finnish markka is ex-

    pected to depreciate against the dollar. Therefore, the
    price of a Finnish sweater sold in the United States

    (true or false?)

    will
    (increase, decrease),
    and the price of U.S. blue jeans sold in Finland will

    As a country’s currency depreciates, international de-

    If a Japanese investor bought the Epic Center office
    building in Wichita, Kansas, the transaction would be
    as

    a

    (increase, decrease).

    (rises,

    If the U.S. dollar drops to 1.1485 euros from 1.1598
    euros, then the dollar has
    ■ a. appreciated against the euro, and the prices of
    European cars will increase in the United States.
    ■ b. appreciated against the euro, and the prices of
    European cars will decrease in the United States.
    ■ c. depreciated against the euro, and the prices of
    European cars will increase in the United States.
    ■ d. depreciated against the euro, and the prices of
    European cars will decrease in the United States.
    ■ e. depreciated against the euro, and the prices of
    American cars will increase in Europe.

    recorded

    in

    Practice Questions and Problems
    1

    List the three factors of production and the name of the
    payments each factor receives. What additional three
    items must be figured in to find gross domestic product?

    2

    A lei maker buys flowers from a nursery for $125.
    She makes 50 leis from the flowers and sells each lei
    for $3.99. What is the value added for the lei maker?

    3

    A Kansas farmer sells wheat to a craftsperson to make
    into decorative ornaments. The farmer sells his wheat
    to the craftsperson for $300. The craftsperson adds
    labor, valued at $200, and some ribbons, valued at $50,
    and produces 110 ornaments. What is the final market

    the

    account.

    ■ a. credit; current
    ■ b. credit; financial
    ■ c. debit; current
    ■ d. debit; financial
    ■ e. credit; investment income
    8

    A country with a deficit in its current account
    ■ a. exports more goods and services than it imports.
    ■ b. is running a deficit in its financial account.
    ■ c. is a net lender to the rest of the world.

    Chapter 10 / Macroeconomic Measures

    (appre-

    ciated, depreciated) against the franc.

    The foreign exchange market, like the New York Stock
    Exchange, is located in a specific building in New

    mand for its products
    falls), all other things being equal.

    Suppose the dollar ended at 1.4165 Swiss francs
    today, well above yesterday’s 1.4045 francs.

    ■ a. The dollar has

    Social security payments are tied to the
    ■ a. GDP price index.
    ■ b. wholesale price index.
    ■ c. CPI.
    ■ d. nominal GDP.
    ■ e. PPI.

    York City.
    5

    9

    value of each ornament?
    4

    Unplanned inventory
    is not) included in the GDP.

    5

    Write the formulas for the following:
    Gross domestic product as expenditures (GDP):

    (is,

    225

    9

    Gross domestic product as income (GDP):

    If the price index in the current year is 212, then
    prices have
    changed, decreased) by
    cent from the base year.

    Gross national product (GNP):
    Net national product (NNP):

    ing exchange rates?
    a. 1 Canadian dollar  $.86610
    b. 1 euro  $.8707
    c. 1 Japanese yen  $.00677
    d. 1 British pound  $1.8155

    Personal income (PI):
    Disposable personal income (DPI):
    Use the following information to calculate GDP,
    GNP, NNP, and NI. All figures are in billions of
    dollars.
    Capital consumption
    allowance
    Corporate profits
    Rents
    Interest
    Net factor income
    from abroad

    7

    328
    124
    6
    264
    43

    costs $150. Using the exchange rates listed in the following table, what would the camera cost in each of
    the following countries?

    Wages and salaries 1,803
    Personal taxes
    398
    Statistical
    273
    discrepancy
    Proprietor’s income 248

    GDP

    GNP

    NNP

    NI

    a. Euro area

    Nominal GDP
    206
    216
    228

    Implicit GDP
    Deflator
    98
    100
    115

    226

    Currency per
    U.S. Dollar
    1.1485
    21.61
    22.66

    c. Philippines

    Exercises and Applications
    Real GDP
    I

    b. Prices in year 3 were
    (higher, lower) than prices in the base year.
    c. During year 3, nominal GDP
    (increased, did not change, decreased)

    U.S. Dollar
    Equivalent
    .8707
    .0463
    .04413

    b. Pakistan

    The following table shows nominal GDP and the implicit GDP deflator for three years. Use this information to calculate the real GDP and to answer the
    following questions.

    a. Which year is the base year?

    8

    11 A digital camera manufactured in the United States

    Country
    Euro area (euro)
    Pakistan (rupee)
    Philippines (peso)

    Year
    1
    2
    3

    per-

    10 What is the price of one U.S. dollar given the follow-

    National income (NI):

    6

    (increased, not

    .

    Why isn’t nominal GDP a good measure of the
    strength or weakness of the economy? What measure
    would be better?

    Understanding Price Indexes Suppose the economy of Strandasville produces only four goods: CDs,
    pizza, desk chairs, and sweaters. The following tables
    show the dollar value of output for three different
    years.
    Number
    Price
    Number
    Price per
    Year
    of CDs
    per CD
    of Pizzas
    Pizza
    1
    1,000
    $5
    8,000
    $6.60
    2
    1,000
    $6
    8,000
    $6.60
    3
    4,000
    $7
    10,000
    $6.80

    Number of Price per
    Number
    Year Desk Chairs Chair
    of Sweaters
    1
    3,000
    $20
    5,000
    2
    3,000
    $25
    5,000
    3
    3,500
    $25
    4,900

    Price per
    Sweater
    $20
    $18
    $15

    Part Three / The National and Global Economies

    1. Calculate the total dollar value of output for year 1,
    year 2, and year 3.

    III The Balance of Payments and Exchange Rates

    If U.S. residents lend and invest less in foreign countries than foreigners lend and invest in the United
    States, the financial account will be in surplus. If U.S.
    purchases of foreign stocks and bonds exceed foreign
    purchases of U.S. stocks and bonds, then more funds
    are leaving the country than entering it, and the financial account will be in deficit. Pretend that you are
    willing to sell your DVD player to a French resident.
    Would you prefer to be paid in U.S. dollars or in euros? Since you can’t easily spend euros in this country, you would prefer to be paid in U.S. dollars. Therefore, if the French buy more U.S. goods and services,
    they will need dollars to pay for them, and the dollar
    will appreciate against the euro. Similarly, if U.S. investors demand more French bonds and stocks, the
    euro will appreciate.
    What impact will a financial account surplus have
    on domestic currency? If U.S. federal budget deficits
    continue, what will be the impact on the dollar?

    2. The dollar value of output in year 2 is higher than
    the dollar value of output in year 1
    a. entirely because of price changes.
    b. entirely because of output changes.
    c. because of both price and output changes.
    3. The dollar value of output in year 3 is higher than
    the dollar value of output in year 2
    a. entirely because of price changes.
    b. entirely because of output changes.
    c. because of both price and output changes.
    The Balance of Payments as an Indicator

    A surplus in the merchandise account means that a nation is
    exporting more goods than it is importing. This is often interpreted as a sign that a nation’s producers can
    produce at a lower cost than their foreign counterparts.
    A trade deficit may indicate that a nation’s producers
    are less efficient than their foreign counterparts.
    Interpret these statements in terms of what you
    have read about the United States as the world’s
    largest debtor nation. Can you explain why many analysts viewed the U.S. balance of payments accounts
    with concern in the mid-1990s?

    Chapter 10 / Macroeconomic Measures



    ACE s

    II

    -test
    elf



    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    227

    Chapter 11

    ?

    Fundamental
    Questions

    1. What is a business
    cycle?
    2. How is the
    unemployment rate
    defined and
    measured?
    3. What is the cost of
    unemployed
    resources?
    4. What is inflation?
    5. Why is inflation a
    problem?

    228

    Unemployment, Inflation,
    and Business Cycles

    I

    f you were graduating from college today, what
    would your job prospects be? In 1932, they would
    have been bleak. A large number of people were
    out of work (about one in four workers), and a large number of firms had laid off
    workers or gone out of business. At any time, job opportunities depend not only on the
    individual’s ability and experience but also on the current state of the economy.
    All economies have cycles of activity: periods of expansion, when output and
    employment increase, followed by periods of contraction, when output and employment decrease. For instance, during the expansionary period of the 1990s,
    fewer than 5 percent of U.S. workers had no job by 1997. But during the period of
    contraction of 1981–1982, 9.5 percent of U.S. workers had no job. When the economy is growing, the demand for goods and services tends to increase. To produce
    those goods and services, firms hire more workers. Economic expansion also has an
    impact on inflation. As the demand for goods and services goes up, the prices of
    those goods and services also tend to rise. By the late 1990s, following several years
    of economic growth, consumer prices in the United States were rising by about 3
    percent a year. During periods of contraction, as more people are out of work, demand for goods and services tends to fall, and there is less pressure for rising prices.
    During the period of the Great Depression in the 1930s in the United States,
    consumer prices fell by more than 5 percent in 1933. Both price increases and the
    fraction of workers without jobs are affected by business cycles in fairly regular
    ways. But their effects on individual standards of living, income, and purchasing
    power are much less predictable.
    Why do certain events move in tandem? What are the links between unemployment and inflation? What causes the business cycle to behave as it does?
    What effect does government activity have on the business cycle and on unemployment and inflation? Who is harmed by rising unemployment and inflation?
    Who benefits? Macroeconomics attempts to answer all of these questions. ■

    Preview

    Part Three / The National and Global Economies

    1. BUSINESS CYCLES

    ?
    1. What is a business
    cycle?

    In this chapter we describe the business cycle and examine measures of unemployment and inflation. We talk about the ways in which the business cycle, unemployment, and inflation are related. And we describe their effects on the participants in
    the economy.
    The most widely used measure of a nation’s output is gross domestic product.
    When we examine the value of real GDP over time, we find periods in which it
    rises and other periods in which it falls.

    1.a. Definitions
    business cycle: pattern of
    rising real GDP followed by
    falling real GDP

    recession: a period in which
    real GDP falls

    This pattern—real GDP rising, then falling—is called a business cycle. The pattern
    occurs over and over again, but as Figure 1 shows, the pattern over time is anything but
    regular. Historically the duration of business cycles and the rate at which real GDP
    rises or falls (indicated by the steepness of the line in Figure 1) vary considerably.
    Looking at Figure 1, it is clear that the U.S. economy has experienced
    up-and-down swings in the years since 1959. Still, real GDP has grown at an average rate of approximately 3 percent per year. While it is important to recognize that
    periods of economic growth, or prosperity, are followed by periods of contraction,
    or recession, it is also important to recognize the presence of long-term economic
    growth; despite the presence of periodic recessions, in the long run the economy
    produces more goods and services. The long-run growth in the economy depends
    on the growth in productive resources, like land, labor, and capital, along with technological advances. Technological change increases the productivity of resources
    so that output increases even with a fixed amount of inputs. In recent years there
    has been concern about the growth rate of U.S. productivity and its effect on the
    long-run growth potential of the economy.

    Figure 1

    11,500

    U.S. Real GDP

    11,000

    Peaks

    Troughs

    April 1960

    February 1961

    December 1969

    November 1970

    10,500
    10,000
    9,500
    9,000
    8,500

    Real GDP (billions of dollars)

    The shaded areas represent periods
    of economic contraction (recession).
    The table lists the dates of businesscycle peaks and troughs. The peak
    dates indicate when contractions
    began; the trough dates, when expansions began.

    8,000
    7,500
    7,000
    6,500
    6,000
    5,500
    5,000

    November 1973

    March 1975

    January 1980

    July 1980

    July 1981

    November 1982

    3,500

    July 1990

    March 1991

    3,000

    March 2001

    November 2001

    Source: Data from Bureau of Economic
    Analysis (http://www.bea.gov).

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    4,500
    4,000

    2,500
    2,000
    0

    1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

    Year

    229

    Figure 2
    The Business Cycle
    Peak
    Real GDP

    The business cycle contains
    four phases: the expansion
    (boom), when real GDP is
    increasing; the peak, which
    marks the end of an expansion and the beginning of a
    contraction; the contraction
    (recession), when real GDP is
    falling; and the trough, which
    marks the end of a contraction and the beginning of an
    expansion.

    Expansion

    Contraction

    Trend

    Trough

    Year 1

    Year 2

    Year 3
    Time

    Year 4

    Year 5

    Figure 2 shows how real GDP behaves over a hypothetical business cycle and
    identifies the stages of the cycle. The vertical axis on the graph measures the level
    of real GDP; the horizontal axis measures time in years. In year 1, real GDP is
    growing; the economy is in the expansion phase, or boom period, of the business
    cycle. Growth continues until the peak is reached, in year 2. Real GDP begins to
    fall during the contraction phase of the cycle, which continues until year 4. The
    trough marks the end of the contraction and the start of a new expansion. Even
    though the economy is subject to periodic ups and downs, real GDP, the measure of
    a nation’s output, has risen over the long term, as illustrated by the upward-sloping
    line labeled Trend.
    If an economy is growing over time, why do economists worry about business cycles? Economists try to understand the causes of business cycles so that they can
    learn to moderate or avoid recessions and their harmful effects on standards of living.

    1.b. Historical Record

    depression: a severe,
    prolonged economic
    contraction

    230

    The official dating of recessions in the United States is the responsibility of the National Bureau of Economic Research (NBER), an independent research organization. The NBER defines a recession as “a period of significant decline in total output, income, employment, and trade, usually lasting from six months to a year, and
    marked by widespread contractions in many sectors of the economy.” People sometimes say that a recession is defined by two consecutive quarters of declining real
    GDP. This informal idea of what constitutes a recession seems consistent with the
    past recessions experienced by the United States since every recession through the
    1990s has had at least two quarters of falling real GDP. However, this is not the official definition of a recession. The business cycle dating committee of the NBER
    generally focuses on monthly data. Close attention is paid to the following monthly
    data series: employment, real personal income less transfer payments, the volume of
    sales of the manufacturing and wholesale-retail sectors adjusted for price changes,
    and industrial production. The focus is not on real GDP since it is only measured
    quarterly and does not permit the identification of the month in which business cycle
    turning points occur. The NBER has identified the shaded areas in the graph in
    Figure 1 as recessions and the unshaded areas as expansions. Recessions are periods
    between cyclical peaks and the troughs that follow them. Expansions are periods between cyclical troughs and the peaks that follow them. There have been 12 recessions since 1929. The most severe was the Great Depression. It occurred between
    1929 and 1933, and national output fell by 25 percent. A depression is a prolonged
    period of severe economic contraction. The fact that people refer to “the Depression” when speaking about the recession that began in 1929 indicates the severity of

    Part Three / The National and Global Economies

    Table 1

    Leading Indicators

    Indicators of the Business
    Cycle

    Average workweek

    New building permits

    Unemployment claims

    Delivery times of goods

    Manufacturers’ new orders

    Interest rate spread

    Stock prices

    Money supply

    New plant and equipment orders

    Consumer expectations

    Coincident Indicators

    Lagging Indicators

    Payroll employment

    Labor cost per unit of output

    Industrial production

    Inventories to sales ratio

    Personal income

    Unemployment duration

    Manufacturing and trade sales

    Consumer credit to personal income ratio
    Outstanding commercial loans
    Prime interest rate
    Inflation rate for services

    that contraction relative to others in recent experience. There was widespread suffering during the Depression. Many people were jobless and homeless, and many firms
    went bankrupt. The most recent recession began in March 2001. This business-cycle
    peak marked the end of a ten-year expansion, the longest in U.S. history.

    1.c. Indicators

    leading indicator: a variable
    that changes before real output
    changes

    coincident indicator: a
    variable that changes at the
    same time that real output
    changes
    lagging indicator: a variable
    that changes after real output
    changes

    We have been talking about the business cycle in terms of real GDP. There are a
    number of other variables that move in a fairly regular manner over the business cycle. The Department of Commerce classifies these variables in three categories—
    leading indicators, coincident indicators, and lagging indicators—depending on
    whether they move up or down before, at the same time as, or following a change in
    real GDP (see Table 1).
    Leading indicators generally change before real GDP changes. As a result,
    economists use them to forecast changes in output. Looking at Table 1, it is easy to
    see how some of these leading indicators could be used to forecast future output.
    For instance, new building permits signal new construction. If the number of new
    permits issued goes up, economists can expect the amount of new construction to
    increase. Similarly, if manufacturers receive more new orders, economists can expect more goods to be produced.
    Leading indicators are not infallible, however. The link between them and future
    output can be tenuous. For example, leading indicators may fall one month and rise
    the next while real output rises steadily. Economists want to see several consecutive months of a new direction in the leading indicators before forecasting a change
    in output. Short-run movements in the indicators can be very misleading.
    Coincident indicators are economic variables that tend to change at the same
    time real output changes. For example, as real output increases, economists expect to
    see employment and sales rise. The coincident indicators listed in Table 1 have
    demonstrated a strong tendency over time to change along with changes in real GDP.
    The final group of variables listed in Table 1, lagging indicators, do not change
    their value until after the value of real GDP has changed. For instance, as output increases, jobs are created and more workers are hired. It makes sense, then, to expect the duration of unemployment (the average time workers are unemployed) to
    fall. The duration of unemployment is a lagging indicator. Similarly, the inflation
    rate for services (which measures how prices change for things like dry cleaners,

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    231

    As real income falls, living standards go down. This 1937 photo
    of a Depression-era breadline indicates the paradox of the
    world’s richest nation, as emphasized on the billboard in the
    background, having to offer public support to feed able-bodied
    workers who are out of work due
    to the severity of the businesscycle downturn.

    veterinarians, and other services) tends to change after real GDP changes. Lagging
    indicators are used along with leading and coincident indicators to identify the
    peaks and troughs in business cycles.

    R E C A P

    ?
    2. How is the unemployment rate defined and
    measured?

    1. The business cycle is a recurring pattern of rising and falling real GDP.
    2. Although all economies move through periods of expansion and contraction,
    the duration of expansion and recession varies.
    3. Real GDP is not the only variable affected by business cycles; leading, lagging, and coincident indicators also show the effects of economic expansion
    and contraction.

    2. UNEMPLOYMENT
    Recurring periods of prosperity and recession are reflected in the nation’s labor markets. In fact, this is what makes understanding the business cycle so important. If
    business cycles signified only a little more or a little less profit for businesses, governments would not be so anxious to forecast or to control their swings. It is the human
    costs of lost jobs and incomes—the inability to maintain standards of living—that
    make an understanding of business cycles and of the factors that affect unemployment so important.

    2.a. Definition and Measurement
    unemployment rate:
    the percentage of the labor
    force that is not working

    232

    The unemployment rate is the percentage of the labor force that is not working.
    The rate is calculated by dividing the number of people who are unemployed by the
    number of people in the labor force:
    number unemployed
    Unemployment rate 
    number in labor force
    Part Three / The National and Global Economies

    Now You Try It
    A survey has been taken of
    1,000 people in a neighborhood. It is found that 800 are
    working full-time. Of the 200
    not working, 100 are housewives or househusbands, 50
    are actively looking for a job,
    20 are retired, and 30 are under 16 years of age. Using the
    definition of the unemployment rate and labor force:
    1. What is the size of the
    neighborhood labor force?
    2. What is the neighborhood
    unemployment rate?

    This ratio seems simple enough, but there are several subtle issues at work here.
    First, the unemployment rate does not measure the percentage of the total population that is not working; it measures the percentage of the labor force that is not
    working. Who is in the labor force? Obviously, everybody who is employed is part
    of the labor force. But only some of those who are not currently employed are
    counted in the labor force.
    The Bureau of Labor Statistics of the Department of Labor compiles labor data
    each month based on an extensive survey of U.S. households. All U.S. residents are
    potential members of the labor force. The Labor Department arrives at the size of
    the actual labor force by using this formula:
    Labor force  all U.S. residents  residents under 16 years of age
     institutionalized adults  adults not looking for work
    So the labor force includes those adults (an adult being 16 or older) currently
    employed or actively seeking work. It is relatively simple to see to it that children
    and institutionalized adults (for instance, those in prison or long-term care facilities) are not counted in the labor force. It is more difficult to identify and accurately
    measure adults who are not actively looking for work.
    A person is actively seeking work if he or she is available to work, has looked
    for work in the past four weeks, is waiting for a recall after being laid off, or is
    starting a job within 30 days. Those who are not working and who meet these criteria are considered unemployed.

    2.b. Interpreting the Unemployment Rate

    discouraged workers: workers
    who have stopped looking for
    work because they believe no
    one will offer them a job

    underemployment: the
    employment of workers in
    jobs that do not utilize their
    productive potential

    Is the unemployment rate an accurate measure? The fact that the rate does not include those who are not actively looking for work is not necessarily a failing. Many
    people who are not actively looking for work—homemakers, older citizens, and
    students, for example—have made a decision to do housework, to retire, or to stay
    in school. These people rightly are not counted among the unemployed.
    But there are people missing from the unemployment statistics who are not
    working and are not looking for work, yet would take a job if one was offered.
    Discouraged workers have looked for work in the past year but have given up
    looking for work because they believe that no one will hire them. These individuals
    are ignored by the official unemployment rate even though they are able to work
    and may have spent a long time looking for work. Estimates of the number of discouraged workers indicate that in 2006, about 1.6 million people were not counted
    in the labor force yet claimed that they were available for work. Of this group,
    396,000 people were considered to be discouraged workers. In this case the reported unemployment rate underestimates the true burden of unemployment in the
    economy because it ignores discouraged workers.
    Discouraged workers are one source of hidden unemployment; underemployment
    is another. Underemployment is the underutilization of workers—employment in
    tasks that do not fully utilize their productive potential—including part-time workers
    who prefer full-time employment. Even if every worker has a job, substantial underemployment leaves the economy producing less than its potential GDP.
    The effect of discouraged workers and underemployment is an unemployment rate
    that understates actual unemployment. In contrast, the effect of the underground economy is a rate that overstates actual unemployment. A sizable component of the officially unemployed is actually working. The unemployed construction worker who
    plays in a band at night may not report that activity because he or she wants to avoid
    paying taxes on his or her earnings as a musician. This person is officially unemployed
    but has a source of income. Many officially unemployed individuals have an alternative source of income. This means that official statistics overstate the true magnitude
    of unemployment. The larger the underground economy, the greater this overstatement. (See the Economic Insight “The Underground Economy.”)

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    233

    Economic Insight

    The Underground Economy

    O

    fficial unemployment data,
    like national income data,
    do not include activity in the
    underground economy. Obviously,
    drug dealers and prostitutes do not
    report their earnings. Nor do many
    of the people who supplement their
    unemployment benefits with parttime jobs. In addition, people like
    the waiter who reports a small fraction of his actual tips and the housecleaning person who requests payment in cash in order to avoid
    reporting taxable income are also
    part of the underground economy.
    Because activity in the underground economy goes unreported,
    there is no exact way to determine
    its size. Estimates range from 5 to 33

    percent of the gross domestic
    product. With the GDP at $13 trillion,
    this places the value of underground
    activity between $65 billion and
    $4 trillion.
    We will never know the true size
    of the underground economy, but
    evidence suggests that it is growing.
    That evidence has to do with cash.
    The vast majority of people working
    in the underground economy are
    paid in cash. One indicator of the
    growth of that economy, then, is the
    rise in currency over time relative to
    checking accounts. Also, per capita
    holdings of $100 bills have increased
    substantially. Certainly, much of the
    demand for $100 bills is a product of
    inflation (as the prices of goods and

    services go up, it is easier to pay for
    them in larger-denomination bills).
    But there is also a substantial rise in
    real holdings of $100 bills as well.
    The underground economy forces
    us to interpret government statistics
    carefully. We must remember that:
    Official income statistics understate the true national income.
    ■ Official unemployment data
    overestimate true unemployment.
    ■ When the underground economy
    grows more rapidly than the rest
    of the economy, the true rate of
    growth is higher than reported.


    We have identified two factors, discouraged workers and underemployment, that
    cause the official unemployment rate to underestimate true unemployment. Another
    factor, the underground economy, causes the official rate to overestimate the true
    rate of unemployment. There is no reason to expect these factors to cancel one
    another out, and there is no way to know for sure which is most important. The point
    is to remember what the official data on unemployment do and do not measure.

    2.c. Types of Unemployment
    Economists have identified four basic types of unemployment:
    Seasonal unemployment. A product of regular, recurring changes in the hiring
    needs of certain industries on a monthly or seasonal basis
    Frictional unemployment. A product of the short-term movement of workers between jobs and of first-time job seekers
    Structural unemployment. A product of technological change and other changes
    in the structure of the economy
    Cyclical unemployment. A product of business-cycle fluctuations
    In certain industries, labor needs fluctuate throughout the year. When local
    crops are harvested, farms need lots of workers; the rest of the year, they do not.
    (Migrant farmworkers move from one region to another, following the harvests, to
    avoid seasonal unemployment.) Ski resort towns like Park City, Utah, are booming during the ski season, when employment peaks, but need fewer workers during the rest of the year. In the nation as a whole, the Christmas season is a time of
    peak employment and low unemployment rates. To avoid confusing seasonal fluctuations in unemployment with other sources of unemployment, unemployment
    data are seasonally adjusted.
    Frictional and structural unemployment exist in any dynamic economy. In terms
    of individual workers, frictional unemployment is short term in nature. Workers quit

    234

    Part Three / The National and Global Economies

    Seasonal unemployment is unemployment that fluctuates with
    the seasons of the year. For instance, these Santas in training
    will be employed from fall
    through Christmas. After Christmas they will be unemployed
    and must seek new positions.
    Other examples of seasonal unemployment include farmworkers who migrate to follow the
    harvest of crops, experiencing unemployment between harvests.

    ?
    3. What is the cost of unemployed resources?

    one job and soon find another; students graduate and soon find a job. This kind of unemployment cannot be eliminated in a free society. In fact, it is a sign of efficiency in
    an economy when workers try to increase their income or improve their working conditions by leaving one job for another. Frictional unemployment is often called
    search unemployment because workers take time to search for a job after quitting a
    job or leaving school.
    Frictional unemployment is short term; structural unemployment, on the other
    hand, can be long term. Workers who are displaced by technological change
    (assembly-line workers who have been replaced by machines, for example) or by a
    permanent reduction in the demand for an industry’s output (cigar makers who
    have been laid off because of a decrease in demand for tobacco) may not have the
    necessary skills to maintain their level of income in another industry. Rather than
    accept a much lower salary, these workers tend to prolong their job search. Eventually they adjust their expectations to the realities of the job market, or they enter the
    pool of discouraged workers.
    Structural unemployment is very difficult for those who are unemployed. But
    for society as a whole, the technological advances that cause structural unemployment raise living standards by giving consumers a greater variety of goods at a
    lower cost.
    Cyclical unemployment is a result of the business cycle. As a recession occurs,
    cyclical unemployment increases, and as growth occurs, cyclical unemployment
    decreases. It is also a primary focus of macroeconomic policy. Economists believe
    that a greater understanding of business cycles and their causes may enable them to
    find ways to smooth out those cycles and swings in unemployment. Much of the
    analysis in future chapters is related to macroeconomic policy aimed at minimizing
    business-cycle fluctuations. In addition to macroeconomic policy aimed at moderating cyclical unemployment, other policy measures—for example, job training
    and counseling—are being used to reduce frictional and structural unemployment.

    2.d. Costs of Unemployment
    The cost of being unemployed is more than the obvious loss of income and status
    suffered by the individual who is not working. In a broader sense, society as a

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    235

    Figure 3
    The GDP Gap
    The GDP gap is the difference between what the economy can produce at the natural rate of unemployment
    (potential GDP) and actual output (actual GDP). When
    the unemployment rate is higher than the natural rate,
    (a) Potential and Real GDP

    actual GDP is less than potential GDP. The gap between
    potential and actual real GDP is a cost associated with unemployment. Recession years are shaded to highlight
    how the gap widens around recessions.
    (b) A Graph of the GDP Gap

    11,500

    300

    11,000

    250

    10,500

    Billions of Dollars

    10,000
    9,500

    Billions of Dollars

    9,000
    8,500
    8,000

    200

    GDP Gap
    150
    100
    50

    7,500
    7,000

    0

    6,500

    Potential GDP

    1975

    1980

    1985

    1990

    1995

    2000

    2005

    Year

    6,000

    Real GDP

    5,500
    5,000
    4,500
    4,000
    1975

    1980

    1985

    1990

    1995

    2000

    2005

    Year

    whole loses when resources are unemployed. Unemployed workers produce no
    output. So an economy with unemployment will operate inside its production possibilities curve rather than on the curve. Economists measure this lost output in
    terms of the GDP gap:
    GDP gap  potential real GDP  actual real GDP
    potential real GDP: the output
    produced at the natural rate of
    unemployment
    natural rate of unemployment:
    the unemployment rate that
    would exist in the absence of
    cyclical unemployment

    236

    Potential real GDP is the level of output produced when nonlabor resources are
    fully utilized and unemployment is at its natural rate. The natural rate of unemployment is the unemployment rate that would exist in the absence of cyclical unemployment, so it includes seasonal, frictional, and structural unemployment. The
    natural rate of unemployment is not fixed; it can change over time. For instance,
    some economists believe that the natural rate of unemployment has risen in recent
    decades, a product of the influx of baby boomers and women into the labor force. As
    more workers move into the labor force (begin looking for jobs), frictional unemployment increases, raising the natural rate of unemployment. The natural rate of
    unemployment is sometimes called the non-accelerating-inflation rate of unemployment, or NAIRU—the idea being that there would be upward pressure on wages and
    prices in a “tight” labor market when the unemployment rate fell below the NAIRU.
    Potential real GDP measures what we are capable of producing at the natural
    rate of unemployment. If we compute potential real GDP and then subtract actual
    real GDP, we have a measure of the output lost as a result of unemployment, or the
    cost of unemployment.
    Part Three / The National and Global Economies

    The GDP gap in the United States for recent decades is shown in Figure 3(a). The
    gap widens during recessions and narrows during expansions. As the gap widens (as
    the output not produced increases), there are fewer goods and services available, and
    living standards are lower than they would be at the natural rate of unemployment.
    Figure 3(b) is a graph of the gap between potential and real GDP, taken from Figure 3(a).
    One can see that the expansion of the 1990s eliminated the GDP gap by 1997.
    Economists used to use the term full employment instead of natural rate of unemployment. Today the term full employment is rarely used because it may be interpreted as implying a zero unemployment rate. If frictional and structural unemployment are always present, zero unemployment is impossible; there must always
    be unemployed resources in an economy. Natural rate of unemployment describes
    the labor market when the economy is producing what it realistically can produce
    in the absence of cyclical unemployment.
    What is the value of the natural rate of unemployment in the United States? In the
    1950s and 1960s, economists generally agreed on 4 percent. By the 1970s, that
    agreed-on rate had gone up to 5 percent. In the early 1980s, many economists placed
    the natural rate of unemployment in the United States at 6 to 7 percent. By the late
    1980s, some had revised their thinking, placing the rate back at 5 percent. In fact,
    economists do not know exactly what the natural rate of unemployment is. Over time
    it varies within a range from around 4 percent to around 7 percent. It will also vary
    across countries, as labor markets and macroeconomic policies differ.

    2.e. The Record of Unemployment
    Unemployment rates in the United States from 1951 to 2006 are listed in
    Table 2. Over this period, the unemployment rate for all workers reached a low of

    Unemployment Rate, Civilian Workers1

    Table 2
    Unemployment Rates
    in the United States

    Females

    Both
    Sexes
    16–19
    Years

    White

    Black

    Hispanic

    2.8

    4.4

    8.2

    3.1





    4.4

    4.2

    4.9

    11.0

    3.9





    5.5

    5.2

    5.9

    14.6

    4.8





    1963

    5.7

    5.2

    6.5

    17.2

    5.0





    1967

    3.8

    3.1

    5.2

    12.9

    3.4





    1971

    5.9

    5.3

    6.9

    16.9

    5.4





    1975

    8.5

    7.9

    9.3

    19.9

    7.8

    14.8

    12.2

    Year

    All
    Civilian
    Workers

    Males

    1951

    3.3

    1955
    1959

    1979

    5.8

    5.1

    6.8

    16.1

    5.1

    12.3

    8.3

    1983

    9.6

    9.9

    9.2

    22.4

    8.4

    19.5

    13.7

    1987

    6.2

    6.2

    6.2

    16.9

    5.3

    13.0

    8.3

    1991

    6.8

    7.2

    6.4

    18.7

    6.1

    12.5

    10.0

    1995

    5.6

    5.6

    5.6

    17.3

    4.9

    10.4

    9.3

    1999

    4.2

    4.1

    4.3

    13.9

    3.7

    8.0

    6.4

    2000

    4.0

    3.9

    4.1

    13.1

    3.5

    7.6

    5.7

    2001

    4.7

    4.8

    4.7

    14.7

    4.2

    8.6

    6.6

    2002

    5.8

    5.9

    5.6

    16.5

    5.1

    10.2

    7.5

    2006

    4.6

    4.6

    4.6

    15.4

    4.0

    8.9

    6.0

    1

    Unemployed as a percentage of the civilian labor force in the group specified.

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    237

    2.8 percent in 1953 and a high of 9.6 percent in 1982 and 1983. The table shows
    some general trends in the incidence of unemployment across different demographic groups:
    In early years, the unemployment rate for women is higher than it is for men.
    Several factors may be at work here. First, during this period, a large number of
    women entered the labor force for the first time. Second, discrimination against
    women in the workplace limited job opportunities for them, particularly early in
    this period. Finally, a large number of women move out of the labor force on
    temporary maternity leaves.
    Teenagers have the highest unemployment rates in the economy. This makes
    sense because teenagers are the least-skilled segment of the labor force.
    Whites have lower unemployment rates than nonwhites. Discrimination plays a
    role here. To the extent that discrimination extends beyond hiring practices and
    job opportunities for minority workers to the education that is necessary to prepare students to enter the work force, minority workers will have fewer opportunities for employment. The quality of education provided in many schools with
    large minority populations may not be as good as that provided in schools with
    large white populations. Equal opportunity programs and legislation are aimed
    at rectifying this inequality.
    Although exact comparisons across countries are difficult to make because
    countries measure unemployment in different ways, it is interesting to look at the
    reported unemployment rates of different countries. Table 3 lists unemployment
    rates for seven major industrial nations. The rates have been adjusted to match as
    closely as possible the U.S. definition of unemployment. For instance, the official
    Italian unemployment data include people who have not looked for work in the past
    30 days. The data for Italy in Table 3 have been adjusted to remove these people. If
    the data had not been adjusted, the Italian unemployment rates would be roughly
    twice as high as those listed.
    Countries not only define unemployment differently; they also use different
    methods to count the unemployed. All major European countries except Sweden
    use a national unemployment register to identify the unemployed. Only those
    people who register for unemployment benefits are considered unemployed.

    Civilian Unemployment Rate (percent)

    Table 3
    Unemployment Rates in
    Major Industrial Countries

    Year

    United
    States

    1960

    5.5

    6.5

    1.5

    3.7

    1.7

    2.2

    1.1

    1965

    4.5

    3.6

    1.6

    3.5

    1.2

    2.1

    .3

    1970

    4.9

    5.7

    2.5

    3.2

    1.2

    3.1

    .5

    1975

    8.5

    6.9

    4.1

    3.4

    1.9

    4.6

    3.4

    1980

    7.1

    7.5

    6.4

    4.4

    2.0

    7.0

    2.9

    1985

    7.2

    10.5

    10.4

    6.0

    2.6

    11.2

    7.5

    1990

    5.5

    8.1

    9.2

    7.0

    2.1

    6.9

    5.0

    1995

    5.6

    9.5

    11.7

    12.0

    3.2

    8.8

    6.5

    2000

    4.0

    5.7

    9.6

    10.6

    4.7

    5.5

    8.3

    2005

    5.1

    6.0

    10.1

    8.1

    4.5

    4.8

    11.2

    Canada

    France

    Italy

    Japan

    United
    Kingdom

    Germany

    Source: Economic Report of the President, 2007 (Washington, D.C.: U.S. Government Printing
    Office, 2007).

    238

    Part Three / The National and Global Economies

    A problem with this method is that it excludes those who have not registered because they are not entitled to benefits, and it includes those who receive benefits
    but would not take a job if one was offered. Other countries—among them the
    United States, Canada, Sweden, and Japan—conduct monthly surveys of households to estimate the unemployment rate. Surveys allow more comprehensive
    analysis of unemployment and its causes than the use of a register does. The Organization for Economic Cooperation and Development, an organization created
    to foster international economic cooperation, compared annual surveys of the labor force in Europe with the official register of unemployment data and found
    that only 80 to 85 percent of those surveyed as unemployed were registered in
    Germany, France, and the United Kingdom. In Italy, only 63 percent of those surveyed as unemployed were registered.
    Knowing their limitations, we can still identify some important trends from the
    data in Table 3. Through the 1960s and early 1970s, European unemployment rates
    generally were lower than U.S. and Canadian rates. Over the next decade, European
    unemployment rates increased substantially, as did the rates in North America. But
    in the mid-1980s, while U.S. unemployment began to fall, European unemployment remained high. The issue of high unemployment rates in Europe has become
    a major topic of discussion at international summit meetings. The Global Business
    Insight “High Unemployment in Europe” discusses this issue further. Japanese unemployment rates, like those in Europe, were much lower than U.S. and Canadian
    rates in the 1960s and 1970s. However, while Japanese rates remained much lower
    in the 1980s and 1990s, by 2000, a prolonged economic slowdown in Japan had led
    to rising unemployment.

    R E C A P

    ?
    4. What is inflation?
    inflation: a sustained rise in
    the average level of prices

    1. The unemployment rate is the number of people unemployed as a percentage
    of the labor force.
    2. To be in the labor force, one must either have or be looking for a job.
    3. By its failure to include discouraged workers and the output lost because of
    underemployment, the unemployment rate understates real unemployment in
    the United States.
    4. By its failure to include activity in the underground economy, the U.S. unemployment rate overstates actual unemployment.
    5. Unemployment data are adjusted to eliminate seasonal fluctuations.
    6. Frictional and structural unemployment are always present in a dynamic
    economy.
    7. Cyclical unemployment is a product of recession; it can be moderated by
    controlling the period of contraction in the business cycle.
    8. Economists measure the cost of unemployment in terms of lost output.
    9. Unemployment data show that women generally have higher unemployment
    rates than men, that teenagers have the highest unemployment rates in the
    economy, and that nonwhites have higher unemployment rates than whites.

    3. INFLATION
    Inflation is a sustained rise in the average level of prices. Notice the word sustained.
    Inflation does not mean a short-term increase in prices; it means prices are rising
    over a prolonged period of time. Inflation is measured by the percentage change in
    the price level. The inflation rate in the United States was 2.5 percent in 2006. This
    means that the level of prices increased 2.5 percent over the year.

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    239

    High Unemployment in Europe

    T

    he data in Table 3 indicate that
    European countries tend to
    have higher unemployment
    rates than other industrial countries.
    This is not true of all European countries, but it is certainly true for the
    biggest: France, Germany, Italy, and
    Spain. One factor that contributes to
    the higher unemployment rates in
    these countries is government policy
    with regard to the labor market.
    Countries that have policies that encourage unemployment should be
    expected to have more unemployed
    workers. In a recent speech, a British
    scholar gave his analysis of why
    Europe has such high unemployment.
    One story he told illustrates how
    government policy aimed at protecting
    citizens against unemployment can
    create the very unemployment that
    is the cause for concern. In Italy, laws
    require parents to support their adult
    children who do not work, even if the
    children are entirely capable of working. The story goes as follows:
    The Italian Court of Cessation
    ruled that a professor at Naples
    University, separated from his
    family, must continue to pay his
    30-year-old son €775 per month
    until he can find himself suitable
    employment. This despite the fact
    that the son owns a house and
    possesses an investment trust
    fund worth €450,000. The judges
    said that an adult son who refused
    work that did not reflect his training, abilities and personal interests
    could not be held to blame. In
    particular the judges said[,] “You
    cannot blame a young person,
    particularly from a well-off family,
    who refuses a job that does not fit
    his aspirations.” By contrast, under
    UK law, a separated father would
    only have to support his children
    until they completed full-time education.” (Stephen Nickell, 2002)
    The government requirement that
    parents support unemployed adult
    children encourages the children to
    remain unemployed.
    Among men of prime working
    age (age 25–54), there are more

    240

    Global Business Insight

    who are inactive and
    not participating in the
    labor force than there
    are unemployed. The
    majority of these men
    are receiving benefits
    from the government
    claiming disability or
    illness. In the 1970s,
    there were many fewer
    disabled or ill workers
    as a fraction of the population. But
    as social benefits were increased,
    and the eligibility rules were relaxed,
    the number claiming to suffer from
    such problems also increased. The
    unfortunate truth of human nature is
    that as you provide better support
    for those who truly need help, there
    will be more and more who do not
    truly need it yet will claim a need.
    The experience of Denmark is instructive in this regard. Denmark has
    generous unemployment benefits.
    But in the 1990s, Danish eligibility
    requirements were tightened, creating greater incentives for the unemployed to look for work. Danish unemployment rates fell dramatically
    as a result.
    Another effect of government
    policy is related to a person’s loss
    of job skills while unemployed. Unemployment benefits in Europe are
    relatively high and can last a long
    time. Unemployment benefits in
    the United States are relatively low
    and have a shorter duration. Given
    just these facts, one would expect
    more European unemployment
    since the unemployed would be
    out of work for a longer time in
    Europe than in the United States. If
    people are not working for a prolonged time, they are more likely to
    find their work skills deteriorating,
    so they are less likely to be attractive candidates for jobs if and when
    they do look for work. Therefore, a
    longer duration of unemployment
    benefits, meant to protect workers
    who lose their jobs, will also contribute to more workers’ job skills
    appearing to be inadequate to
    employers when the workers do
    apply for employment.

    Germany

    France
    Spain
    Italy

    Other factors contributing to
    higher unemployment rates in some
    countries are the restrictions on the
    ability of firms to terminate workers
    and the requirement that firms pay
    high separation costs to workers
    who are fired. The more difficult it is
    for firms to adjust their labor force in
    the face of economic fluctuations,
    the less likely firms are to hire new
    workers. If you own a business and
    your sales increase, you are more
    likely to hire extra employees to
    meet the increased demand for your
    product. However, you cannot be
    sure that your sales will remain
    higher permanently, so you would
    be very conservative about hiring
    new workers if you would have to
    pay terminated workers a large
    amount of money if sales fell and
    you needed to lay off some of your
    employees. Such labor market rigidities, aimed at protecting workers
    from losing jobs, create incentives
    against hiring so that those who
    would like to work cannot get hired.
    The lesson learned from large European countries is that government
    policies aimed at protecting workers
    from unemployment may create a
    bigger unemployment problem.
    Then the costs imposed on the economy in terms of taxes and reduced
    labor market flexibility may exceed
    the benefits to those who keep their
    jobs or receive unemployment compensation because of the programs.
    Sources: Stephen Nickell, “A Picture of
    European Unemployment: Success and
    Failure,” speech given to CESifo Conference in Munich, December 2002; and
    Lars Ljungqvist and Thomas Sargent, “The
    European Unemployment Dilemma,”
    Journal of Political Economy, 1998.

    Part Three / The National and Global Economies

    3.a. Absolute Versus Relative Price Changes
    In the modern economy, over any given period, some prices rise faster than others.
    To evaluate the rate of inflation in a country, then, economists must know what is
    happening to prices on average. Here it is important to distinguish between absolute and relative price changes.
    Let’s look at an example using the prices of fish and beef:

    1 pound of fish
    1 pound of beef

    Year 1

    Year 2

    $1
    $2

    $2
    $4

    In year 1, beef is twice as expensive as fish. This is the price of beef relative to
    fish. In year 2, beef is still twice as expensive as fish. The relative prices have not
    changed between years 1 and 2. What has changed? The prices of both beef and
    fish have doubled. The absolute levels of all prices have gone up, but because they
    have increased by the same percentage, the relative prices are unchanged.
    Inflation measures changes in absolute prices. In our example, all prices doubled, so the inflation rate is 100 percent. There was a 100 percent increase in the
    prices of beef and fish. Inflation does not proceed evenly through the economy.
    Prices of some goods rise faster than others, which means that relative prices are
    changing at the same time that absolute prices are rising. The measured inflation
    rate records the average change in absolute prices.

    ?
    5. Why is inflation a
    problem?

    3.b. Effects of Inflation
    To understand the effects of inflation, you have to understand what happens to the
    value of money in an inflationary period. The real value of money is what it can
    buy, its purchasing power:
    $1
    Real value of $1 
    price level
    The higher the price level, the lower the real value (or purchasing power) of the
    dollar. For instance, suppose an economy had only one good—milk. If a glass of
    milk sold for $.50, then one dollar would buy two glasses of milk. If the price of
    milk rose to $1, then a dollar would only buy one glass of milk. The purchasing
    power, or real value, of money falls as prices rise.
    Table 4 lists the real value of the dollar in selected years from 1946 to 2006. The
    price level in each year is measured relative to the average level of prices over the
    1982–1984 period. For instance, the 1946 value, 0.195, means that prices in 1946
    were, on average, only 19.5 percent of prices in the 1982–1984 period. Notice that
    as prices go up, the purchasing power of the dollar falls. In 1946, a dollar bought
    five times more than a dollar bought in the early 1980s. The value 5.13 means that
    one could buy 5.13 times more goods and services with a dollar in 1946 than one
    could in 1982–1984.
    Prices have risen steadily in recent decades. By 2006, they had gone up more
    than 100 percent above the average level of prices in the 1982–1984 period. Consequently, the purchasing power of a 2006 dollar was lower. In 2006, $1 bought just 47
    percent of the goods and services that one could buy with a dollar in 1982–1984.
    If prices and nominal income rise by the same percentage, it might seem that inflation is not a problem. It doesn’t matter whether it takes twice as many dollars now
    to buy fish and beef as it did before if we have twice as many dollars in income
    available to buy the products. Obviously, inflation is very much a problem when a
    household’s nominal income rises at a slower rate than prices. Inflation hurts those
    households whose income does not keep up with the prices of the goods they buy.
    In the 1970s in the United States, the rate of inflation rose to near-record levels.
    Many workers believed that their incomes were lagging behind the rate of inflation,

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    241

    Table 4

    Year

    The Real Value of a Dollar

    1946

    5.13

    1950

    0.241

    4.15

    1954

    0.269

    3.72

    1958

    0.289

    3.46

    1962

    0.302

    3.31

    1966

    0.324

    3.09

    1970

    0.388

    2.58

    1974

    0.493

    2.03

    1978

    0.652

    1.53

    1982

    0.965

    1.04

    1986

    1.096

    0.91

    1990

    1.307

    0.77

    1994

    1.482

    0.67

    1997

    1.608

    0.62

    2000

    1.722

    0.58

    2003

    1.840

    0.54

    2006

    2.018

    0.47

    2

    real interest rate: the nominal
    interest rate minus the rate of
    inflation

    242

    Purchasing Power of a Dollar2

    0.195

    1

    nominal interest rate: the
    observed interest rate in the
    market

    Average Price Level1

    Measured by the consumer price index as given in http://data.bls.gov/.
    Found by taking the reciprocal of the consumer price index (1/CPI).

    so they negotiated cost-of-living raises in their wage contracts. The typical cost-ofliving raise ties salary to changes in the consumer price index. If the CPI rises 8
    percent over a year, workers receive an 8 percent raise plus compensation for experience or productivity increases. As the U.S. rate of inflation fell during the 1980s,
    concern about cost-of-living raises subsided as well.
    It is important to distinguish between expected and unexpected inflation. Unexpectedly high inflation redistributes income away from those who receive fixed incomes (like creditors who receive debt repayments of a fixed amount of dollars per
    month) toward those who make fixed expenditures (like debtors who make fixed
    debt repayments per month). For example, consider a simple loan agreement.
    Maria borrows $100 from Ali, promising to repay the loan in one year at 10 percent interest. In one year, Maria will pay Ali $110—principal of $100 plus interest
    of $10 (10 percent of $100, or $10).
    When Maria and Ali agree to the terms of the loan, they do so with some expected rate of inflation in mind. Suppose they both expect 5 percent inflation
    over the year. In one year it will take 5 percent more money to buy goods than it
    does now. Ali will need $105 to buy what $100 buys today. Because Ali will receive $110 for the principal and interest on the loan, he will gain purchasing
    power. However, if the inflation rate over the year turns out to be surprisingly
    high—say, 15 percent—then Ali will need $115 to buy what $100 buys today. He
    will lose purchasing power if he makes a loan at a 10 percent rate of interest.
    Economists distinguish between nominal and real interest rates when analyzing
    economic behavior. The nominal interest rate is the observed interest rate in the
    market and includes the effect of inflation. The real interest rate is the nominal interest rate minus the rate of inflation:
    Real interest rate  nominal interest rate  rate of inflation
    If Ali charges Maria 10 percent nominal interest, and the inflation rate is 5 percent, the real interest rate is 5 percent (10  5  5 percent). This means that Ali
    Part Three / The National and Global Economies

    will earn a positive real return from the loan. However, if the inflation rate is 10
    percent, the real return from a nominal interest rate of 10 percent is zero
    (10  10  0). The interest Ali will receive from the loan will just compensate him
    for the rise in prices; he will not realize an increase in purchasing power. If the inflation rate is higher than the nominal interest rate, then the real interest rate is negative; the lender will lose purchasing power by making the loan.
    Now you can see how unexpected inflation redistributes income. Borrowers and
    creditors agree to loan terms on the basis of what they expect the rate of inflation to
    be over the period of the loan. If the actual rate of inflation turns out to be different
    from what was expected, then the real interest rate paid by the borrower and received by the lender will be different from what was expected. If Ali and Maria
    both expect a 5 percent inflation rate and agree to a 10 percent nominal interest rate
    for the loan, then they both expect a real interest rate of 5 percent (10  5  5 percent) to be paid on the loan. If the actual inflation rate turns out to be greater than 5
    percent, then the real interest rate will be less than expected. Maria will get to borrow Ali’s money at a lower real cost than she expected, and Ali will earn a lower
    real return than he expected. Unexpectedly high inflation hurts creditors and benefits borrowers because it lowers real interest rates.
    Figure 4 shows the real interest rates on U.S. Treasury bills. You can see a
    pronounced pattern in the graph. In the late 1970s, there was a period of negative real
    interest rates, followed by high positive real rates in the 1980s. The evidence suggests
    that nominal interest rates did not rise fast enough in the 1970s to offset high inflation.
    This was a time of severe strain on many creditors, including savings and loan associations and banks. These firms had lent funds at fixed nominal rates of interest. When

    Figure 4
    The Real Interest Rate on U.S. Treasury Bills

    Real Interest Rate (percent)

    The real interest rate is the difference between the nominal rate (the rate actually observed) and the rate of inflation over the life of the bond. The figure shows the real
    interest rate in June and December for each year. For instance, in the first observation for June 1970, a six-month
    Treasury bill paid the holder 6.91 percent interest. This is
    the nominal rate of interest. To find the real rate of interest on the bond, we subtract the rate of inflation that

    existed over the six months of the bond’s life (June to
    December 1970), which was 5.17 percent. The difference
    between the nominal interest rate (6.91 percent) and the
    rate of inflation (5.17 percent) is the real interest rate,
    1.74 percent. Notice that real interest rates were negative
    during most of the 1970s and then turned highly positive
    (by historical standards) in the early 1980s.

    11
    10
    9
    8
    7
    6
    5
    4
    3
    2
    1
    0
    –1
    –2
    –3
    –4
    –5
    1970

    1975

    1980

    1985

    1990

    1995

    2000

    2005

    Year

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    243

    those rates of interest turned out to be lower than the rate of inflation, the financial institutions suffered significant losses. In the early 1980s, the inflation rate dropped
    sharply. Because nominal interest rates did not drop nearly as fast as the rate of inflation, real interest rates were high. In this period many debtors were hurt by the high
    costs of borrowing to finance business or household expenditures.
    Unexpected inflation affects more than the two parties to a loan. Any contract
    calling for fixed payments over some long-term period changes in value as the
    rate of inflation changes. For instance, a long-term contract that provides union
    members with 5 percent raises each year for five years gives the workers more
    purchasing power if inflation is low than if it is high. Similarly, a contract that
    sells a product at a fixed price over a long-term period will change in value as inflation changes. Suppose a lumber company promises to supply a builder with
    lumber at a fixed price for a two-year period. If the rate of inflation in one year
    turns out to be higher than expected, the lumber company will end up selling the
    lumber for less profit than it had planned. Inflation raises costs to the lumber
    company. Usually the company would raise its prices to compensate for higher
    costs. Because the company contracted to sell its goods at a fixed price to the
    builder, however, the builder benefits at the lumber company’s expense. Again,
    unexpectedly high inflation redistributes real income or purchasing power away
    from those receiving fixed payments to those making fixed payments.
    One response to the effects of unexpected inflation is to allow prices, wages, or interest rates to vary with the rate of inflation. Labor sometimes negotiates cost-of-living
    adjustments as part of new wage contracts. Financial institutions offer variable interest
    rates on home mortgages to reflect current market conditions. Any contract can be
    written to adjust dollar amounts over time as the rate of inflation changes.

    3.c. Types of Inflation

    demand-pull inflation:
    inflation caused by increasing
    demand for output
    cost-push inflation: inflation
    caused by rising costs of
    production

    244

    Economists often classify inflation according to the source of the inflationary pressure. The most straightforward method defines inflation in terms of pressure from
    the demand side of the market or the supply side of the market. Demand-pull inflation is caused by increasing demand for output. Increases in total spending that
    are not offset by increases in the supply of goods and services cause the average
    level of prices to rise. Cost-push inflation is caused by rising costs of production.
    Increases in production costs cause firms to raise prices to avoid losses.
    Sometimes inflation is blamed on “too many dollars chasing too few goods.” This
    is a roundabout way of saying that the inflation stems from demand pressures. Because demand-pull inflation is a product of increased spending, it is more likely to
    occur in an economy that is producing at maximum capacity. If resources are fully
    employed, in the short run it may not be possible to increase output to meet increased
    demand. The result: existing goods and services are rationed by rising prices.
    Some economists claim that rising prices in the late 1960s were a product of
    demand-pull inflation. They believe that increased government spending for the
    Vietnam War caused the level of U.S. prices to rise.
    Cost-push inflation can occur in any economy, whatever its output. If prices go
    up because the costs of resources are rising, the rate of inflation can go up regardless of demand.
    For example, some economists argue that the inflation in the United States in the
    1970s was largely due to rising oil prices. This means that decreases in the oil supply (a shift to the left in the supply curve) brought about higher oil prices. Because
    oil is so important in the production of many goods, higher oil prices led to increases in prices throughout the economy. Cost-push inflation stems from changes
    in the supply side of the market.
    Cost-push inflation is sometimes attributed to profit-push or wage-push pressures.
    Profit-push pressures are created by suppliers who want to increase their profit margins by raising prices faster than their costs increase. Wage-push pressures are created

    Part Three / The National and Global Economies

    by labor unions and workers who are able to increase their wages faster than their productivity. There have been times when “greedy” businesses and unions have been
    blamed for periods of inflation in the United States. The problem with these “theories”
    is that people have always wanted to improve their economic status and always will. In
    this sense, people have always been greedy. But inflation has not always been a problem. Were people less greedy in the early 1980s when inflation was low than they were
    in the late 1970s when inflation was high? Obviously, we have to look to other reasons
    to explain inflation. We discuss some of those reasons in later chapters.

    3.d. The Inflationary Record
    Many people today, having always lived with inflation, are surprised to learn that
    inflation is a relatively new problem for the United States. From 1789, when the
    U.S. Constitution was ratified, until 1940, there was no particular trend in the general price level. At times prices rose, and at times they fell. The average level of
    prices in 1940 was approximately the same as it was in the late eighteenth century.
    Since 1940, prices in the United States have gone up markedly. The price level
    today is eight times what it was in 1940. But the rate of growth has varied. Prices
    rose rapidly for the first couple of years following World War II and then grew at a
    relatively slow rate through the 1950s and 1960s. In the early 1970s, the rate of inflation began to accelerate. Prices climbed quickly until the early 1980s, when inflation slowed.
    Annual rates of inflation for several industrial and developing nations are shown
    in Table 5. Look at the diversity across countries: rates range from –3.3 percent in
    Japan to 18.9 percent in Zambia.

    Table 5

    Country

    Rates of Inflation for
    Selected Countries, 2005

    Selected industrial

    Inflation Rate (percent)

    Canada

    3.2

    Germany

    0.4

    Italy

    2.5

    Japan

    – 3.3

    United Kingdom

    2.1

    United States

    2.7

    Selected developing
    Botswana

    9.3

    Brazil

    7.2

    Egypt
    Hong Kong, China

    5.4
    – 0.2

    India

    4.2

    Israel

    0.6

    Mexico

    5.4

    Philippines

    6.0

    Poland

    1.6

    South Africa

    5.0

    Turkey

    5.4

    Zambia

    18.9

    Note: Data are average annual percentage changes in the GDP price index as reported by the
    World Bank. (http://www.worldbank.org).

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    245

    hyperinflation: an extremely
    high rate of inflation

    Hyperinflation is an extremely high rate of inflation. In most cases hyperinflation eventually makes a country’s currency worthless and leads to the introduction of a new currency. Argentina experienced hyperinflation in the 1980s.
    People had to carry large stacks of currency for small purchases. Cash registers
    and calculators ran out of digits as prices reached ridiculously high levels. After
    years of high inflation, Argentina replaced the old peso with the peso Argentino
    in June 1983. The government set the value of 1 peso Argentino equal to 10,000
    old pesos (striking four zeros from all prices). A product that sold for 10,000 old
    pesos before the reform sold for 1 new peso after. But Argentina did not follow
    up its monetary reform with a noninflationary change in economic policy. In
    1984 and 1985, the inflation rate exceeded 600 percent each year. As a result, in
    June 1985, the government again introduced a new currency, the austral, setting
    its value at 1,000 pesos Argentino. However, the economic policy associated with
    the introduction of the austral only lowered the inflation rate temporarily. By
    1988, the inflation rate was over 300 percent, and in 1989, the inflation rate was
    over 3,000 percent. The rapid rise in prices associated with the austral resulted in
    the introduction of yet another currency, again named peso Argentino, in January
    1992, with a value equal to 10,000 australes. This new peso was fixed at a value
    of 1 peso per 1 U.S. dollar, and this exchange rate lasted for about ten years due
    to reasonably stable inflation in Argentina. In late 2001, Argentina experienced
    another financial crisis due to large governent budget deficits, and the fixed rate
    of exchange between the peso and dollar ended, but the peso has remained the
    currency of Argentina. In coming chapters we will learn how monetary and fiscal
    policy of government can create high inflation and how low and stable inflation
    results from sound macroeconomic policy.
    The most dramatic hyperinflation in modern times occurred in Europe after
    World War I. Table 6 shows how the price level rose in Germany between 1914 and
    1924 in relation to prices in 1914. For instance, the value in 1915, 126, indicates
    that prices were 26 percent higher that year than in 1914. The value in 1919, 262,
    indicates that prices were 162 percent higher that year than in 1914. By 1924,
    German prices were more than 100 trillion times higher than they had been in
    1914. At the height of the inflation, the mark was virtually worthless.

    Table 6
    German Wholesale Prices,
    1914–1924

    Year
    Index

    Price

    1914

    100

    1915

    126

    1916

    150

    1917

    156

    1918

    204

    1919

    262

    1920

    1,260

    1921

    1,440

    1922

    3,670

    1923

    278,500

    1924

    117,320,000,000,000

    Source: J. P. Young, European Currency and
    Finance (Washington, D.C.: U.S. Government
    Printing Office, 1925).

    246

    Part Three / The National and Global Economies

    In later chapters, we will see how high rates of inflation generally are caused by
    rapid growth of the money supply. When a central government wants to spend
    more than it is capable of funding through taxation or borrowing, it simply issues
    money to finance its budget deficit. As the money supply increases faster than the
    demand to hold it, spending increases and prices go up.

    R E C A P

    1. Inflation is a sustained rise in the average level of prices.
    2. The higher the price level, the lower the real value (purchasing power) of money.
    3. Unexpectedly high inflation redistributes income away from those who receive fixed-dollar payments (like creditors) toward those who make fixeddollar payments (like debtors).
    4. The real interest rate is the nominal interest rate minus the rate of inflation.
    5. Demand-pull inflation is a product of increased spending; cost-push inflation
    reflects increased production costs.
    6. Hyperinflation is a very high rate of inflation that often results in the introduction of a new currency.

    SUMMARY
    ?

    1.
    2.
    3.

    ?

    4.
    5.
    6.
    7.

    What is a business cycle?

    Business cycles are recurring changes in real GDP, in
    which expansion is followed by contraction.
    The four stages of the business cycle are expansion
    (boom), peak, contraction (recession), and trough.
    Leading, coincident, and lagging indicators are variables that change in relation to changes in output.
    How is the unemployment rate defined and
    measured?

    The unemployment rate is the percentage of the labor
    force that is not working.
    To be in the U.S. labor force, an individual must be
    working or actively seeking work.
    Unemployment can be classified as seasonal, frictional, structural, or cyclical.
    Frictional and structural unemployment are always
    present in a dynamic economy; cyclical unemployment is a product of recession.

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    ?

    8.

    ?

    What is the cost of unemployed resources?

    The GDP gap measures the output lost because of unemployment.
    What is inflation?

    9.

    Inflation is a sustained rise in the average level of
    prices.
    10. The higher the level of prices, the lower the purchasing power of money.
    ?

    Why is inflation a problem?

    11. Inflation becomes a problem when income rises at a
    slower rate than prices.
    12. Unexpectedly high inflation hurts those who receive
    fixed-dollar payments (like creditors) and benefits
    those who make fixed-dollar payments (like debtors).
    13. Inflation can stem from demand-pull or cost-push
    pressures.
    14. Hyperinflation—an extremely high rate of inflation—
    can force a country to introduce a new currency.

    247

    EXERCISES
    1.

    What is the labor force? Do you believe that the U.S.
    government’s definition of the labor force is a good
    one—that it includes all the people it should include?
    Explain your answer.
    Suppose you are able bodied and intelligent, but lazy.
    You would rather sit home and watch television than
    work, even though you know you could find an acceptable job if you looked.
    a. Are you officially unemployed?
    b. Are you a discouraged worker?
    Does the GDP gap measure all of the costs of unemployment? Why or why not?
    Why do teenagers have the highest unemployment
    rate in the economy?
    Write an equation that defines the real interest rate.
    Use the equation to explain why unexpectedly high inflation redistributes income from creditors to debtors.

    2.

    3.
    4.
    5.

    6.

    Many home mortgages in recent years have been made
    with variable interest rates. Typically, the interest rate is
    adjusted once a year based on the current rates on government bonds. How do variable interest rate loans protect creditors from the effects of unexpected inflation?
    The word cycle suggests a regular, recurring pattern of
    activity. Is there a regular pattern in the business cycle?
    Support your answer by examining the duration (number
    of months) of each expansion and contraction in Figure 1.

    7.

    Internet
    Exercise

    248

    8.

    9.

    Suppose 500 people were surveyed, and of those 500,
    450 were working full time. Of the 50 not working, 10
    were full-time college students, 20 were retired, 5 were
    under 16 years of age, 5 had stopped looking for work
    because they believed there were no jobs for them, and
    10 were actively looking for work.
    a. How many of the 500 surveyed are in the labor
    force?
    b. What is the unemployment rate among the 500 surveyed people?
    Consider the following price information:
    Year 1

    Year 2

    Cup of coffee

    $ .50

    $1.00

    Glass of milk

    $1.00

    $2.00

    a. Based on the information given, what was the inflation rate between year 1 and year 2?
    b. What happened to the price of coffee relative to
    that of milk between year 1 and year 2?
    10. Use a supply and demand diagram to illustrate:
    a. Cost-push inflation caused by a labor union successfully negotiating for a higher wage
    b. Demand-pull inflation caused by an increase in demand for domestic products from foreign buyers

    Use the Internet to explore unemployment and labor statistics.
    Go to the Boyes/Melvin Fundamentals of Economics website accessible through
    http://college.hmco.com/pic/boyesfund4e and click on the Internet Exercise link
    for Chapter 11. Now answer the questions that appear on the Boyes/Melvin website.

    Part Three / The National and Global Economies

    Study Guide for Chapter 11
    ■ d. contraction, trough, boom, and expansion.
    ■ e. recession, contraction, peak, and boom.

    Key Term Match
    Match each term with its correct definition by placing
    the appropriate letter next to the corresponding number.
    A.
    B.
    C.
    D.
    E.
    F.
    G.
    H.
    I.

    business cycle
    recession
    depression
    leading indicator
    coincident indicator
    lagging indicator
    unemployment rate
    discouraged workers
    underemployment
    1.
    2.
    3.
    4.
    5.
    6.
    7.
    8.
    9.
    10.
    11.
    12.
    13.
    14.
    15.
    16.
    17.

    To arrive at the number of workers in the U.S. labor
    force, we subtract all of the following from the number of all U.S. residents except
    ■ a. residents under 16 years old.
    ■ b. institutionalized adults.
    ■ c. adults who are not looking for work.
    ■ d. unemployed adults.
    ■ e. All of the above must be subtracted from the
    number of U.S. residents to arrive at the number
    of workers in the labor force.

    3

    Which of the following cause(s) the unemployment
    rate to be overstated?
    ■ a. discouraged workers
    ■ b. underground economic activities
    ■ c. part-time employment
    ■ d. underemployment
    ■ e. students who are not looking for work

    4

    A person who finds that her skills are no longer
    needed because she has been replaced by a machine is
    an example of
    ■ a. frictional unemployment.
    ■ b. seasonal unemployment.
    ■ c. cyclical unemployment.
    ■ d. search unemployment.
    ■ e. structural unemployment.

    5

    A steelworker who has been laid off during a recession is an example of
    ■ a. frictional unemployment.
    ■ b. seasonal unemployment.
    ■ c. cyclical unemployment.
    ■ d. search unemployment.
    ■ e. structural unemployment.

    6

    Which of the following statements is false?
    ■ a. The GDP gap widens during recessions and narrows during expansions.
    ■ b. The natural rate of unemployment varies over
    time and across countries.
    ■ c. Men have higher unemployment rates than
    women because women move out of the labor
    force to have children.
    ■ d. Teenagers have the highest unemployment rates
    in the economy.
    ■ e. Nonwhites have higher unemployment rates
    than whites.

    J. potential real GDP
    K. natural rate of
    unemployment
    L. inflation
    M. nominal interest rate
    N. real interest rate
    O. demand-pull inflation
    P. cost-push inflation
    Q. hyperinflation

    a period in which real GDP falls
    a sustained rise in the average level of prices
    the nominal interest rate minus the rate of inflation
    the pattern of rising real GDP followed by falling
    real GDP
    a variable that changes before real output
    changes
    an extremely high rate of inflation
    the unemployment rate that would exist in the
    absence of cyclical unemployment
    inflation caused by increasing demand for output
    a severe, prolonged economic contraction
    the observed interest rate in the market
    the percentage of the labor force that is not
    working
    the output produced at the natural rate of
    unemployment
    the employment of workers in jobs that do not
    utilize their productive potential
    a variable that changes at the same time that real
    output changes
    inflation caused by rising costs of production
    a variable that changes after real output changes
    workers who have stopped looking for work
    because they believe no one will offer them
    a job

    Quick-Check Quiz
    1

    2

    In correct sequence, the four stages of the business cycle are
    ■ a. peak, boom, expansion, and contraction.
    ■ b. peak, contraction, trough, and expansion.
    ■ c. recession, expansion, peak, and boom.

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    249

    7

    8

    If a college professor’s income has increased by 3 percent at the same time that prices have risen by 5 percent, the professor’s real income has

    2

    The
    marks the end of a contraction and the start of a new business cycle.

    ■ a. decreased by 2 percent.
    ■ b. increased by 2 percent.
    ■ c. increased by 7 percent.
    ■ d. decreased by 7 percent.
    ■ e. not changed.

    3

    The
    marks the end of the expansion phase of a business cycle.

    4

    Real

    Which of the following groups benefits from unexpectedly high inflation?

    ■ a. creditors
    ■ b. retirees on fixed incomes
    ■ c. debtors
    ■ d. workers whose salaries are tied to the CPI
    ■ e. suppliers who have contracted to supply
    Which of the following statements is true?
    ■ a. The higher the price level, the higher the purchasing power of money.
    ■ b. Demand-pull inflation can be a result of increased production costs.
    ■ c. High rates of inflation are generally caused by
    rapid growth of the money supply.
    ■ d. Unexpectedly high inflation redistributes income away from those who make fixed-dollar
    payments toward those who receive fixed-dollar
    payments.
    ■ e. The real interest rate increases as the rate of inflation increases.

    falls

    the

    contraction,

    or

    , phase of the business

    5

    Which organization has the responsibility of officially
    dating recessions in the United States?

    6

    unemployment is a product
    of business-cycle fluctuations.

    7

    unemployment is a product
    of regular, recurring changes in the hiring needs
    of certain industries over the months or seasons of
    the year.

    8

    unemployment is a product
    of short-term movements of workers between jobs
    and of first-time job seekers.

    9

    unemployment is a product
    of technological change and other changes in the
    structure of the economy.

    10 Potential real GDP minus actual real GDP equals the

    10 A lender who does not expect any change in the

    price level is willing to make a mortgage loan at a 10
    percent rate of interest. If that same lender anticipates a future inflation rate of 5 percent, she will
    charge the borrower
    ■ a. 5 percent interest.
    ■ b. 10 percent interest.
    ■ c. 15 percent interest.
    ■ d. 2 percent interest.
    ■ e. .5 percent interest.

    during

    cycle.

    a fixed amount of their product for a fixed price
    9

    GDP

    .
    11 The

    existence

    of

    and

    causes the official unemployment rate in the United States to be understated.
    12 Economists measure the cost of unemployment in

    terms of

    .

    13 The higher the price level, the

    (higher, lower) the purchasing power of the dollar.

    Practice Questions and Problems
    1

    When real GDP is growing, the economy is in the
    phase, or boom period, of
    the business cycle.

    250

    14 Unexpectedly high inflation hurts

    (creditors, debtors) and benefits
    (creditors, debtors) because it lowers real interest
    rates.

    Part Three / The National and Global Economies

    Exercises and Applications
    I

    III Economic Reporting

    Assume you are a reporter for
    the Wall Street Journal. Respond to the following developments. You should consider whether the indicator
    in question leads, lags, or moves with the economy.

    In or Out of the Labor Force? The Department of
    Labor defines the labor force as all U.S. residents minus residents under 16 years old minus institutionalized adults minus adults who are not looking for
    work. A person is seeking work if he or she is available to work, has looked for work in the past four
    weeks, is waiting for a recall after being laid off, or is
    starting a job within 30 days.

    1. The Commerce Department has just released its index of leading indicators, which rose only 0.1 percent in April after dropping 1 percent the previous
    month. What can you tell your readers about the
    probable growth of the economy?

    Place an X next to the description of those who would
    be considered part of the labor force.
    Per Olsen is a Norwegian citizen who is looking
    for a job in the United States. He plans to move
    to the United States to marry his American
    sweetheart.
    Carl Wolcutt is a retired police chief who has
    recently been offered a position as head of his
    state’s police academy. Mr. Wolcutt is happily
    raising beagles and has turned down the job.
    Blake Stephans has just been laid off from his
    quality-control job at Boeing. He is waiting for
    a recall, but the company has just announced it
    will lay off even more workers.
    Thomas Butting is a recent college graduate
    who quit his part-time job but is taking the summer off before searching for a “real” job.
    Joe Shocker, a pitcher on Wichita State University’s baseball team, has been selected in the first
    round of the draft and expects to join the Mets after he finishes playing in the College World Series. In the meantime, he will enjoy the sights and
    sounds of beautiful downtown Omaha.

    3. Stock prices rose in April, up 4.8 percent from
    March.

    4. The Commerce Department originally reported
    that the economy grew at a 1.8 percent annual rate
    in the first quarter. What measure was released?
    The figures were revised after the U.S. trade deficit
    increased sharply in March. Would your estimate
    of economic growth be revised upward or downward as a result of the trade figures?

    Illustrating the Business Cycle The horizontal
    axis measures time, and the vertical axis measures economic activity. Label the points on the following diagram with the appropriate phases of the business cycle.

    ✸✔

    ACE s

    Economic Activity

    II

    2. The Commerce Department reported that new
    plant and equipment orders were flat in April after
    a 3.7 percent decline in March. What does this
    news imply about the economy?

    Time

    Chapter 11 / Unemployment, Inflation, and Business Cycles

    -test
    elf

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    251

    Chapter 12

    Macroeconomic Equilibrium:
    Aggregate Demand and Supply

    Fundamental
    Questions

    otal output and income in the United States
    have grown over time. Each generation has experienced a higher living standard than the previous generation. Yet, as we learned in Chapter 11, economic growth has not been
    steady. Economies go through periods of expansion followed by periods of contraction or recession, and such business cycles have major impacts on people’s lives, incomes, and living standards.
    Economic stagnation and recession throw many, often those who are already
    relatively poor, out of their jobs and into real poverty. Economic growth increases
    the number of jobs and draws people out of poverty and into the mainstream of
    economic progress. To understand why economies grow and why they go through
    cycles, we must discover why firms decide to produce more or less and why buyers
    decide to buy more or less. The approach we take is similar to the approach we followed in the early chapters of the text using demand and supply curves. In Chapters 2
    and 3, demand and supply curves were derived and used to examine questions
    involving the equilibrium price and quantities demanded and supplied of a single
    good or service. This simple yet powerful microeconomic technique of analysis has
    a macroeconomic counterpart—aggregate demand and aggregate supply, which are
    used to determine an equilibrium price level and quantity of goods and services
    produced for the entire economy. In this chapter we use aggregate demand and supply curves to illustrate the causes of business cycles and economic growth. ■

    ?

    1. What is aggregate
    demand?
    2. What causes the
    aggregate demand
    curve to shift?
    3. What is aggregate
    supply?
    4. Why does the shortrun aggregate supply
    curve become
    steeper as real GDP
    increases?
    5. Why is the long-run
    aggregate supply
    curve vertical?
    6. What causes the
    aggregate supply
    curve to shift?
    7. What determines the
    equilibrium price
    level and real GDP?

    ?
    1. What is aggregate
    demand?

    252

    T

    Preview

    1. AGGREGATE DEMAND, AGGREGATE SUPPLY,
    AND BUSINESS CYCLES
    What causes economic growth and business cycles? We can provide some answers
    to this important question using aggregate demand (AD) and aggregate supply (AS)
    curves. Suppose we represent the economy in a simple demand and supply diagram, as shown in Figure 1. Aggregate demand represents the total spending in the
    economy at alternative price levels. Aggregate supply represents the total output of
    the economy at alternative price levels. To understand the causes of business cycles
    and inflation, we must understand how aggregate demand and supply cause the
    equilibrium price level and real GDP, the nation’s output of goods and services, to

    Part Three / The National and Global Economies

    Figure 1
    Aggregate Demand and
    Aggregate Supply
    Equilibrium
    Price Level

    The equilibrium price level
    and real GDP are determined
    by the intersection of the AD
    and AS curves.

    AS

    Pe

    AD

    Ye
    Real GDP

    change. The intersection between the AD and AS curves defines the equilibrium
    level of real GDP and level of prices. The equilibrium price level is Pe and the equilibrium level of real GDP is Ye. This price and output level represents the level of
    prices and output for some particular period of time, say 2005. Once that equilibrium is established, there is no tendency for prices and output to change until
    changes occur in either the aggregate demand curve or the aggregate supply curve.
    Let’s first consider a change in aggregate demand and then look at a change in
    aggregate supply.

    1.a. Aggregate Demand and Business Cycles
    An increase in aggregate demand is illustrated by a shift of the AD curve to the
    right, like the shift from AD1 to AD2 in Figure 2. This represents a situation in
    which buyers are buying more at every price level. The shift causes the equilibrium

    Figure 2
    Effects of a Change
    in Aggregate Demand

    P e2
    Price Level

    If aggregate demand increases from AD1 to AD2, the
    equilibrium price level
    increases to Pe2 and the
    equilibrium level of real GDP
    rises to Ye2. If aggregate
    demand decreases from AD1
    to AD3, the equilibrium price
    level falls to Pe3 and the
    equilibrium level of real GDP
    drops to Ye3.

    AS 1

    P e1
    P e3
    AD 2

    AD 1
    AD3

    Y e3 Y e1 Y e2
    Real GDP

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    253

    Figure 3

    AS 3

    Effects of a Change in
    Aggregate Supply

    AS 1
    Price Level

    If aggregate supply increases
    from AS1 to AS2, the equilibrium price level falls from Pe1
    to Pe 2 and the equilibrium
    level of real GDP rises to Ye 2.
    If aggregate supply decreases
    from AS1 to AS3, the equilibrium price level rises to Pe 3
    and the equilibrium level of
    real GDP falls to Ye 3.

    AS 2

    P e3
    P e1
    P e2

    AD 1

    Y e3 Y e 1 Y e 2
    Real GDP

    level of real GDP to rise from Ye1 to Ye2, illustrating the expansionary phase of the
    business cycle. As output rises, unemployment decreases. The increase in aggregate demand also leads to a higher price level, as shown by the change in the price
    level from Pe1 to Pe2. The increase in the price level represents an example of
    demand-pull inflation, which you may recall, is inflation caused by increasing
    demand for output.
    If aggregate demand falls, like the shift from AD1 to AD3, then there is a lower
    equilibrium level of real GDP, Ye3. In this case, buyers are buying less at every price
    level. The drop in real GDP caused by lower demand would represent an economic
    slowdown or a recession, when output falls and unemployment rises.

    1.b. Aggregate Supply and Business Cycles
    Changes in aggregate supply can also cause business cycles. Figure 3 illustrates
    what happens when aggregate supply changes. An increase in aggregate supply is
    illustrated by the shift from AS1 to AS2, leading to an increase in the equilibrium
    level of real GDP from Ye1 to Ye2. An increase in aggregate supply comes about
    when firms produce more at every price level. Such an increase could result from
    an improvement in technology or a decrease in costs of production.
    If aggregate supply decreased, as in the shift from AS1 to AS3, then the equilibrium level of real GDP would fall to Ye3, and the equilibrium price level would increase from Pe1 to Pe3. A decrease in aggregate supply could be caused by higher
    production costs that lead producers to raise their prices. This is an example of
    cost-push inflation, where the price level rises due to increased costs of production
    and the associated decrease in aggregate supply.

    1.c. A Look Ahead
    Business cycles result from changes in aggregate demand, from changes in aggregate supply, and from changes in both aggregate demand and aggregate supply. The
    degree to which real GDP declines during a recession or increases during an expansion depends on the amount by which the AD and/or AS curves shift. The degree to
    which an expansion involves output growth or increased inflation depends on the
    shapes of the AD and AS curves. We need to consider why the curves have the
    shapes they do, and what causes them to shift.

    254

    Part Three / The National and Global Economies

    The comparison we made earlier, between aggregate demand, aggregate supply,
    and their microeconomic counterparts, the supply and demand curves, is only superficial. As we examine the aggregate demand and supply curves, you will see that the
    reasons underlying the shapes and movements of AD and AS are in fact quite different
    from those explaining the shapes and movements of the supply and demand curves.

    R E C A P

    1. Aggregate demand (AD) represents the total spending in the economy at alternative price levels.
    2. Aggregate supply (AS) represents the total output of the economy at alternative price levels.
    3. The intersection between the AD and AS curves defines the equilibrium level
    of real GDP and the level of prices.
    4. Business cycles result from changes in AD and/or AS.

    2. FACTORS THAT INFLUENCE AGGREGATE DEMAND
    Aggregate demand is the relation between aggregate expenditures, or total spending, and the price level. Aggregate expenditures are the sum of expenditures of
    each sector of the economy: households (consumption), business firms (investment), government, and the rest of the world (net exports). Each sector of the economy has different reasons for spending; for instance, household spending depends
    heavily on household income while business spending depends on the profits businesses expect to earn. Because each sector of the economy has a different reason
    for the amount of spending it undertakes, aggregate spending depends on all of
    these reasons. To understand aggregate demand, therefore, requires that we look at
    those factors that influence the expenditures of each sector of the economy.

    2.a. Consumption
    How much households spend depends on their income, wealth, expectations about
    future prices and incomes, demographics like the age distribution of the population, and taxes.









    Income. If current income rises, households purchase more goods and services.
    Wealth. Wealth is different from income. It is the value of assets owned by a
    household, including homes, cars, bank deposits, stocks, and bonds. An increase in household wealth will increase consumption.
    Expectations. Expectations regarding future changes in income or wealth can
    affect consumption today. If households expect a recession and worry about
    job loss, consumption tends to fall. On the other hand, if households become
    more optimistic regarding future increases in income and wealth, consumption rises today.
    Demographics. Demographic change can affect consumption in several different
    ways. Population growth is generally associated with higher consumption for an
    economy. Younger households and older households generally consume more
    and save less than middle-aged households. Therefore, as the age distribution of
    a nation changes, so will consumption.
    Taxes. Higher taxes will lower the disposable income of households and
    decrease consumption while lower taxes will raise disposable income and
    increase consumption. Government policy may change taxes and thereby
    bring about a change in consumption.

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    255

    2.b. Investment
    Investment is business spending on capital goods and inventories. In general, investment depends on the expected profitability of such spending, so any factor that
    could affect the profitability will be a determinant of investment. Factors affecting
    the expected profitability of business projects include the interest rate, technology,
    the cost of capital goods, and capacity utilization.







    Interest rate. Investment is negatively related to the interest rate. The interest
    rate is the cost of borrowed funds. The greater the cost of borrowing, other
    things being equal, the fewer investment projects that offer sufficient profit to
    be undertaken. As the interest rate falls, investment is stimulated as the cost
    of financing the investment is lowered.
    Technology. New production technology stimulates investment spending as
    firms are forced to adopt new production methods to stay competitive.
    Cost of capital goods. If machines and equipment purchased by firms rise in
    price, then the higher costs associated with investment will lower profitability
    and investment will fall.
    Capacity utilization. The more excess capacity (unused capital goods) is
    available, the more firms can expand production without purchasing new capital goods, and the lower investment is. As firms approach full capacity, more
    investment spending is required to expand output further.

    2.c. Government Spending
    Government spending may be set by government authorities independent of current
    income or other determinants of aggregate expenditures.

    2.d. Net Exports
    Net exports are equal to exports minus imports. We assume exports are determined
    by conditions in the rest of the world, like foreign income, tastes, prices, exchange
    rates, and government policy. Imports are determined by similar domestic factors.








    Income. As domestic income rises and consumption rises, some of this consumption includes goods produced in other countries. Therefore, as domestic
    income rises, imports rise, and net exports fall. Similarly, as foreign income
    rises, foreign residents buy more domestic goods, and net exports rise.
    Prices. Other things being equal, higher (lower) foreign prices make domestic goods relatively cheaper (more expensive) and increase (decrease) net exports. Higher (lower) domestic prices make domestic goods relatively more
    expensive (cheaper) and decrease (increase) net exports.
    Exchange rates. Other things being equal, a depreciation of the domestic currency on the foreign exchange market will make domestic goods cheaper to
    foreign buyers and make foreign goods more expensive to domestic residents
    so that net exports will rise. An appreciation of the domestic currency will
    have just the opposite effects.
    Government policy. Net exports may fall if foreign governments restrict the
    entry of domestic goods, reducing domestic exports. If the domestic government restricts imports into the domestic economy, net exports may rise.

    2.e. Aggregate Expenditures
    You can see how aggregate expenditures, the sum of all spending on U.S. goods and
    services, must depend on prices, income, and all of the other determinants discussed
    in the previous sections. As with the demand curve for a specific good or service,
    with the aggregate demand curve we want to classify the factors that influence

    256

    Part Three / The National and Global Economies

    spending into the price and the nonprice determinants for the aggregate demand
    curves as well. The components of aggregate expenditures that change as the price
    level changes will lead to movements along the aggregate demand curve—changes
    in quantity demanded—while changes in aggregate expenditures caused by nonprice effects will cause shifts of the aggregate demand curve—changes in aggregate demand.

    R E C A P

    1. Aggregate expenditures are the sum of consumption, investment, government
    spending, and net exports.
    2. Consumption depends on household income, wealth, expectations, demographics, and taxation.
    3. Investment depends on the interest rate, technology, the cost of capital goods,
    and capacity utilization.
    4. Government spending is determined independent of current income.
    5. Net exports depend on foreign and domestic incomes, prices, government
    policies, and exchange rates.

    3. THE AGGREGATE DEMAND CURVE
    When we examined the demand curves in Chapter 2, we divided our study into two
    parts: the movement along the curves—changes in quantity demanded—and the shifts
    of the curve—changes in demand. We take the same approach here in examining
    aggregate demand. We first look at the movements along the aggregate demand curve
    caused by changes in the price level. We then turn to the nonprice determinants of
    aggregate demand that cause shifts in the curve.

    3.a. Changes in Aggregate Quantity Demanded:
    Price-Level Effects
    Aggregate demand curves are downward sloping just like the demand curves for
    individual goods that were shown in Chapter 2, although for different reasons.
    Along the demand curve for an individual good, the price of that good changes
    while the prices of all other goods remain constant. This means that the good in
    question becomes relatively more or less expensive compared to all other goods in
    the economy. Consumers tend to substitute a less expensive good for a more expensive good. The effect of this substitution is an inverse relationship between price
    and quantity demanded. As the price of a good rises, quantity demanded falls. For
    the economy as a whole, however, it is not a substitution of a less expensive good
    for a more expensive good that causes the demand curve to slope down. Instead,
    aggregate quantity demanded, or total spending, will change as the price level
    changes due to the wealth effect, the interest rate effect, and the international trade
    effect of a price-level change on aggregate expenditures.

    wealth effect: a change in the
    real value of wealth that causes
    spending to change when the
    level of prices changes

    3.a.1. The Wealth Effect Individuals and businesses own money, bonds, and
    other financial assets. The purchasing power of these assets is the quantity of goods
    and services the assets can be exchanged for. When the level of prices falls, the purchasing power of these assets increases, allowing households and businesses to
    purchase more. When prices go up, the purchasing power of financial assets falls,
    which causes households and businesses to spend less. This is the wealth effect
    (sometimes called the real-balance effect) of a price change: a change in the real
    value of wealth that causes spending to change when the level of prices changes.

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    257

    Real values are values that have been adjusted for price-level changes. Here real
    value means “purchasing power.” When the price level changes, the purchasing
    power of financial assets also changes. When prices rise, the real value of assets
    and wealth falls, and aggregate expenditures tend to fall. When prices fall, the real
    value of assets and wealth rises, and aggregate expenditures tend to rise.
    3.a.2. The Interest Rate Effect When the price level rises, the purchasing
    power of each dollar falls, which means more money is required to buy any particular quantity of goods and services (see Figure 4). Suppose that a family of three
    needs $100 each week to buy food. If the price level doubles, the same quantity of
    food costs $200. The household must have twice as much money to buy the same
    amount of food. Conversely, when prices fall, the family needs less money to buy
    food because the purchasing power of each dollar is greater.
    When prices go up, people need more money. So they sell their other financial
    assets, like bonds, to get that money. The increase in the supply of bonds lowers
    bond prices and raises interest rates. Since bonds typically pay fixed-dollar interest
    payments each year, as the price of a bond varies, the interest rate (or yield) will
    change. For instance, suppose you pay $1,000 for a bond that pays $100 a year in
    interest. The interest rate on this bond is found by dividing the annual interest

    Figure 4
    The Interest Rate Effect

    Rise in
    Price Level

    Fall in
    Price Level

    258

    Decrease in
    Purchasing Power
    of Money

    More Money
    Needed to Buy
    Same Quantity of
    Goods and Services

    Bonds Sold
    to Acquire
    More Money

    Aggregate
    Expenditures
    Fall

    Investment
    Falls

    Interest
    Rates Rise

    Increase in
    Purchasing Power
    of Money

    Less Money
    Needed to Buy
    Same Quantity of
    Goods and Services

    Money Used
    to Buy
    Bonds

    Aggregate
    Expenditures
    Rise

    Investment
    Rises

    Interest
    Rates Fall

    Part Three / The National and Global Economies

    interest rate effect: a change
    in interest rates that causes
    investment and therefore
    aggregate expenditures to
    change as the level of prices
    changes

    international trade effect: a
    change in aggregate
    expenditures resulting from a
    change in the domestic price
    level that changes the price of
    domestic goods in relation to
    foreign goods

    aggregate demand curve: a
    curve that shows the different
    levels of expenditures on
    domestic output at different
    levels of prices

    payment by the bond price, or $100/$1,000  10 percent. If the price of the bond
    falls to $900, then the interest rate is equal to the annual interest payment (which
    remains fixed at $100 for the life of the bond) divided by the new price of $900:
    $100/$900  11 percent. When bond prices fall, interest rates rise, and when bond
    prices rise, interest rates fall.
    If people want more money, and they sell some of their bond holdings to raise
    the money, bond prices will fall, and interest rates will rise. The rise in interest rates
    is necessary to sell the larger quantity of bonds, but it causes investment expenditures to fall, which causes aggregate expenditures to fall.
    When prices fall, people need less money to purchase the same quantity of
    goods, so they use their money holdings to buy bonds and other financial assets.
    The increased demand for bonds increases bond prices and causes interest rates to
    fall. Lower interest rates increase investment expenditures, thereby pushing aggregate expenditures up.
    Figure 4 shows the interest rate effect, the relationship among the price level,
    interest rates, and aggregate expenditures. As the price level rises, interest rates
    rise, and aggregate expenditures fall. As the price level falls, interest rates fall, and
    aggregate expenditures rise.
    3.a.3. The International Trade Effect The third channel through which a
    price-level change affects the quantity of goods and services demanded is called
    the international trade effect. A change in the level of domestic prices can cause
    net exports to change. If domestic prices rise while foreign prices and the foreign
    exchange rate remain constant, domestic goods become more expensive in relation
    to foreign goods.
    Suppose the United States sells oranges to Japan. If the oranges sell for $1 per
    pound, and the yen–dollar exchange rate is 100 yen  $1, a pound of U.S. oranges
    costs a Japanese buyer 100 yen. What happens if the level of prices in the United
    States goes up 10 percent? All prices, including the price of oranges, increase 10
    percent. The U.S. oranges sell for $1.10 a pound after the price increase. If the exchange rate is still 100 yen  $1, a pound of oranges now costs the Japanese buyer
    110 yen (100  1.10). If orange prices in other countries do not change, some
    Japanese buyers may buy oranges from those countries. The increase in the level of
    U.S. prices makes U.S. goods more expensive relative to foreign goods and causes
    U.S. net exports to fall; a decrease in the level of U.S. prices makes U.S. goods
    cheaper in relation to foreign goods and causes U.S. net exports to rise.
    When the price of domestic goods increases in relation to the price of foreign
    goods, net exports fall, causing aggregate expenditures to fall. When the price of domestic goods falls in relation to the price of foreign goods, net exports rise, causing
    aggregate expenditures to rise. The international trade effect of a change in the level
    of domestic prices causes aggregate expenditures to change in the opposite direction.
    3.a.4. The Sum of the Price-Level Effects The aggregate demand curve
    (AD) shows how the equilibrium level of expenditures for the economy’s output
    changes as the price level changes. In other words, the curve shows the amount
    people spend at different price levels.
    Figure 5 displays the typical shape of the AD curve. The price level is plotted on
    the vertical axis, and real GDP is plotted on the horizontal axis. Suppose that initially the economy is at point A with prices at P0. At this point, spending equals
    $500. If prices fall to P1, expenditures equal $700, and the economy is at point C. If
    prices rise from P0 to P2, expenditures equal $300 at point B.
    Because aggregate expenditures increase when the price level decreases and decrease when the price level increases, the aggregate demand curve slopes down.
    The aggregate demand curve is drawn with the price level for the entire economy
    on the vertical axis. A price-level change here means that, on average, all prices
    in the economy change; there is no relative price change among domestic goods.

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    259

    Figure 5
    The Aggregate Demand
    Curve

    B

    P2
    Price Level

    The aggregate demand curve
    (AD) shows the level of
    expenditures at different
    price levels. At price level P0,
    expenditures are $500; at P1,
    $700; and at P2, $300.

    A

    P0

    C

    P1

    AD
    0

    100

    200

    300

    400

    500

    600

    700

    Real GDP (dollars)

    ?
    2. What causes the aggregate demand curve to
    shift?

    The negative slope of the aggregate demand curve is a product of the wealth effect,
    the interest rate effect, and the international trade effect.
    A lower domestic price level increases consumption (the wealth effect), investment (the interest rate effect), and net exports (the international trade effect). As the
    price level drops, aggregate expenditures rise.
    A higher domestic price reduces consumption (the wealth effect), investment
    (the interest rate effect), and net exports (the international trade effect). As prices
    rise, aggregate expenditures fall. These price effects are summarized in Figure 6.

    3.b. Changes in Aggregate Demand: Nonprice Determinants
    The aggregate demand curve shows the level of aggregate expenditures at alternative price levels. We draw the curve by varying the price level and finding out what
    the resulting total expenditures are, holding all other things constant. As those
    “other things”—the nonprice determinants of aggregate demand—change, the
    aggregate demand curve shifts. The nonprice determinants of aggregate demand
    include all of the factors covered in the discussion of the components of expenditures—income, wealth, demographics, expectations, taxes, the interest rate (interest
    rates can change for reasons other than price-level changes), the cost of capital
    goods, capacity utilization, foreign income and price levels, exchange rates, and
    government policy. A change in any one of these can cause the AD curve to shift. In
    the discussions that follow, we will focus particularly on the effect of expectations,
    foreign income levels, and price levels, and we will also mention government policy,
    which will be examined in detail in Chapter 13. Figure 7 summarizes these effects,
    which are discussed next.
    3.b.1. Expectations Consumption and business spending are affected by expectations. Consumption is sensitive to people’s expectations of future income,
    prices, and wealth. For example, when people expect the economy to do well in the
    future, they increase consumption today at every price level. This is reflected in a
    shift of the aggregate demand curve to the right, from AD0 to AD1, as shown in
    Figure 8. When aggregate demand increases, aggregate expenditures increase at
    every price level.
    On the other hand, if people expect a recession in the near future, they tend to
    reduce consumption and increase saving in order to protect themselves against a
    greater likelihood of losing a job or a forced cutback in hours worked. As consumption

    260

    Part Three / The National and Global Economies

    Figure 6
    Why the Aggregate Demand Curve Slopes Down
    (a) Wealth Effect (b) Interest Rate Effect (c) International Trade Effect

    (a) Wealth Effect
    Change in
    Purchasing Power
    of Financial Assets

    Change in
    Price Level

    Change in
    Consumption

    Change in
    Aggregate
    Expenditures

    Change in
    Demand
    for Bonds

    Change in
    Interest
    Rates

    (b) Interest Rate Effect
    Change in
    Desired
    Money Holdings

    Change in
    Price Level

    Change in
    Aggregate
    Expenditures

    Change in
    Investment

    Change in
    Net Exports

    Change in
    Aggregate
    Expenditures

    (c) International Trade Effect

    Change in
    Price Level

    Change in Price
    of Domestic Goods
    Relative to
    Foreign Goods

    drops, aggregate demand decreases. The AD curve shifts to the left, from AD0 to
    AD2. At every price level along AD2, planned expenditures are less than they are
    along AD0.
    Expectations also play an important role in investment decisions. Before undertaking a particular project, businesses forecast the likely revenues and costs associated with that project. When the profit outlook is good—say, a tax cut is on the
    horizon—investment and therefore aggregate demand increase. When profits are
    expected to fall, investment and aggregate demand decrease.
    3.b.2. Foreign Income and Price Levels When foreign income increases, so
    does foreign spending. Some of this increased spending is for goods produced in

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    261

    Figure 7
    Nonprice Determinants: Changes in Aggregate Demand
    (a) Expectations (b) Foreign Income and Price Levels
    (c) Government Policy

    (a) Expectations

    Expect Future
    Income Increase (Decrease)

    Consumption Increases
    (Decreases) Today

    Aggregate Demand
    Increases (Decreases)

    Domestic Exports
    Rise (Fall)

    Aggregate Demand
    Increases (Decreases)

    (b) Foreign Income and Price Levels

    Foreign Income or Price
    Rises (Falls)

    (c) Government Policy

    Government Spending
    Increases (Decreases)

    Aggregate Demand
    Increases (Decreases)

    Taxes Decrease (Increase)

    Consumption
    Increases (Decreases)

    Aggregate Demand
    Increases (Decreases)

    the domestic economy. As domestic exports increase, aggregate demand rises.
    Lower foreign income has just the opposite effect. As foreign income falls, foreign
    spending falls, including foreign spending on the exports of the domestic economy.
    Lower foreign income, then, causes domestic net exports and domestic aggregate
    demand to fall.
    If foreign prices rise in relation to domestic prices, domestic goods become less
    expensive relative to foreign goods, and domestic net exports increase. This means
    that aggregate demand rises, or the aggregate demand curve shifts up, as the level
    of foreign prices rises. Conversely, when the level of foreign prices falls, domestic

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    Part Three / The National and Global Economies

    Figure 8

    Increase in
    Aggregate
    Demand

    As aggregate demand
    increases, the AD curve shifts
    to the right, like the shift from
    AD0 to AD1. At every price
    level, the quantity of output
    demanded increases. As
    aggregate demand falls, the
    AD curve shifts to the left, like
    the shift from AD0 to AD2. At
    every price level, the quantity
    of output demanded falls.

    Price Level

    Shifting the Aggregate
    Demand Curve

    Decrease in
    Aggregate
    Demand

    AD 2

    AD 0

    AD 1

    Real GDP

    goods become more expensive relative to foreign goods, causing domestic net exports and aggregate demand to fall.
    Let’s go back to the market for oranges. Suppose U.S. growers compete with
    Brazilian growers for the Japanese orange market. If the level of prices in Brazil
    rises while the level of prices in the United States remains stable, the price of
    Brazilian oranges to the Japanese buyer rises in relation to the price of U.S. oranges. What happens? The U.S. exports of oranges to Japan should rise while
    Brazilian exports of oranges to Japan fall.
    3.b.3. Government Policy One of the goals of macroeconomic policy is to
    achieve economic growth without inflation. For GDP to increase, either AD or AS
    would have to change. Government economic policy can cause the aggregate demand curve to shift. An increase in government spending or a decrease in taxes will
    increase aggregate demand; a decrease in government spending or an increase in
    taxes will decrease aggregate demand. We devote Chapter 13, “Fiscal Policy,” to an
    examination of the effect of taxes and government spending on aggregate demand.
    In Chapter 15, “Monetary Policy,” we describe how changes in the money supply
    can cause the aggregate demand curve to shift.

    R E C A P

    1. The aggregate demand curve shows the level of aggregate expenditures at
    different levels of price.
    2. Aggregate expenditures are the sum of consumption, investment, government
    spending, and net exports.
    3. The wealth effect, the interest rate effect, and the international trade effect
    are three reasons why aggregate demand slopes down. These effects explain
    movements along a given AD curve.
    4. The aggregate demand curve shifts with changes in the nonprice determinants of aggregate demand: expectations, foreign income and price levels,
    and government policy.

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    263

    ?
    3. What is aggregate
    supply?
    aggregate supply curve: a
    curve that shows the amount
    of real GDP produced at
    different price levels

    4. AGGREGATE SUPPLY
    The aggregate supply curve shows the quantity of real GDP produced at different
    price levels. The aggregate supply (AS ) curve looks like the supply curve for an individual good, but, as with aggregate demand and the microeconomic demand
    curve, different factors are at work. The positive relationship between price and
    quantity supplied of an individual good is based on the price of that good’s changing in relation to the prices of all other goods. As the price of a single good rises
    relative to the prices of other goods, sellers are willing to offer more of the good for
    sale. With aggregate supply, on the other hand, we are analyzing how the amount of
    all goods and services produced changes as the level of prices changes. The direct
    relationship between prices and national output is explained by the effect of changing prices on profits, not by relative price changes.

    4.a. Changes in Aggregate Quantity Supplied:
    Price-Level Effects
    Along the aggregate supply curve, everything is held fixed except the price level
    and output. The price level is the price of output. The prices of resources, that is,
    the costs of production—wages, rent, and interest—are assumed to be constant, at
    least for a short time following a change in the price level.
    If the price level rises while the costs of production remain fixed, business profits go up. As profits rise, firms are willing to produce more output. As the price
    level rises, then, the quantity of output firms are willing to supply increases. The
    result is the positively sloped aggregate supply curve shown in Figure 9.
    As the price level rises from P0 to P1 in Figure 9, real GDP increases from $300
    to $500. The higher the price level, the higher are the profits, everything else held
    constant, and the greater is the quantity of output produced in the economy. Conversely, as the price level falls, the quantity of output produced falls.

    4.b. Short-Run Versus Long-Run Aggregate Supply
    The curve in Figure 9 is a short-run aggregate supply curve because the costs of
    production are held constant. Although production costs may not rise immediately

    Figure 9

    AS

    Aggregate Supply

    P1
    Price Level

    The aggregate supply curve
    shows the amount of real
    GDP produced at different
    price levels. The AS curve
    slopes up, indicating that the
    higher the price level, the
    greater the quantity of output
    produced.

    P0

    0

    100

    200

    300

    400

    500

    600

    700

    Real GDP (dollars)

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    Part Three / The National and Global Economies

    Figure 10

    AS

    The upward-sloping aggregate supply curve occurs
    when the price level must
    rise to induce further increases in output. The curve
    gets steeper as real GDP increases since the closer the
    economy comes to the capacity level of output, the less
    output will rise in response to
    higher prices as more and
    more firms reach their maximum level of output in the
    short run.

    Price Level

    The Shape of the Short-Run
    Aggregate Supply Curve

    Real GDP

    ?
    4. Why does the short-run
    aggregate supply curve
    become steeper as real
    GDP increases?

    ?
    5. Why is the long-run
    aggregate supply curve
    vertical?

    long-run aggregate supply
    curve (LRAS): a vertical line at
    the potential level of national
    income

    when the price level rises, eventually they will. Labor will demand higher wages to
    compensate for the higher cost of living; suppliers will charge more for materials.
    The positive slope of the AS curve, then, is a short-run phenomenon. How short is
    the short run? It is the period of time over which production costs remain constant.
    (In the long run, all costs change or are variable.) For the economy as a whole, the
    short run can be months or, at most, a few years.
    4.b.1. Short-Run Aggregate Supply Curve Figure 9 represents the general
    shape of the short-run aggregate supply curve. In Figure 10 you see a more realistic
    version of the same curve; its steepness varies. The steepness of the aggregate supply curve depends on the ability and willingness of producers to respond to pricelevel changes in the short run. Figure 10 shows the typical shape of the short-run
    aggregate supply curve.
    Notice that as the level of real GDP increases in Figure 10, the AS curve becomes steeper. This is because each increase in output requires firms to hire more
    and more resources until eventually full capacity is reached in some areas of the
    economy, resources are fully employed, and some firms reach maximum output. At
    this point, increases in the price level bring about smaller and smaller increases in
    output from firms as a whole. The short-run aggregate supply curve becomes increasingly steep as the economy approaches maximum output.
    4.b.2. Long-Run Aggregate Supply Curve Aggregate supply in the short run
    is different from aggregate supply in the long run (see Figure 11). That difference
    stems from the fact that quantities and costs of resources are not fixed in the long
    run. Over time, contracts expire and wages and other resource costs adjust to current conditions. The increased flexibility of resource costs in the long run has costs
    rising and falling with the price level and changes the shape of the aggregate supply
    curve. Lack of information about economic conditions in the short run also contributes to the inflexibility of resource prices as compared to the long run.
    The long-run aggregate supply curve (LRAS) is viewed by most economists
    to be a vertical line at the potential level of real GDP or output (Yp), as shown in
    Figure 11. Remember that the potential level of real GDP is the income level that is
    produced in the absence of any cyclical unemployment, or when the natural rate of
    unemployment exists. In the long run, wages and other resource costs fully adjust

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    265

    Figure 11

    LRAS

    In the long run, the AS curve
    is a vertical line at the potential level of real GDP. This
    indicates that there is no
    relationship between pricelevel changes and the quantity of output produced.

    Price Level

    The Shape of the Long-Run
    Aggregate Supply Curve

    Yp
    Real GDP

    ?
    6. What causes the
    aggregate supply curve
    to shift?

    to price changes. The short-run AS curve slopes up because we assume that the
    costs of production, particularly wages, do not change to offset changing prices. In
    the short run, then, higher prices increase producers’ profits and stimulate production. In the long run, because the costs of production adjust completely to the
    change in prices, neither profits nor production increases. What we find here are
    higher wages and other costs of production to match the higher level of prices.

    4.c. Changes in Aggregate Supply: Nonprice Determinants
    The aggregate supply curve is drawn with everything but the price level and real
    GDP held constant. There are several things that can change and cause the aggregate supply curve to shift. The shift from AS0 to AS1 in Figure 12 represents an increase in aggregate supply. The AS1 curve lies to the right of AS0; this means that at

    Technological advance shifts the
    aggregate supply curve outward
    and increases output. An
    example of a technological
    advance that has increased
    efficiency in banking is the
    automated teller machine (ATM).
    The photo shows an ATM in
    Brazil that allows the bank to offer the public a lower-cost way to
    make withdrawals and deposits
    than dealing with a bank
    employee. Such innovations can
    be important determinants of
    aggregate supply.

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    Part Three / The National and Global Economies

    Figure 12

    AS 2

    Changes in Aggregate
    Supply

    AS 1
    Price Level

    The aggregate supply curve
    shifts with changes in resource prices, technology,
    and expectations. When aggregate supply increases, the
    curve shifts to the right, like
    the shift from AS0 to AS1, so
    that at every price level more
    is being produced. When aggregate supply falls, the curve
    shifts to the left, like the shift
    from AS0 to AS2, so that at
    every price level less is being
    produced.

    AS 0

    Decrease in
    Aggregate
    Supply
    Increase in
    Aggregate
    Supply

    Real GDP

    every price level, production is higher on AS1 than on AS0. The shift from AS0 to
    AS2 represents a decrease in aggregate supply. The AS2 curve lies to the left of AS0;
    this means that at every price level, production along AS2 is less than along AS0. The
    nonprice determinants of aggregate supply are resource prices, technology, and expectations. Figure 13 summarizes the nonprice determinants of aggregate supply.
    4.c.1. Resource Prices When the price of output changes, the costs of production do not change immediately. At first, then, a change in profits induces a change
    in production. Costs eventually change in response to the change in prices and production, and when they do, the aggregate supply curve shifts. When the cost of
    resources—labor, capital goods, materials—falls, the aggregate supply curve shifts
    to the right, from AS0 to AS1 in Figure 12. This means firms are willing to produce
    more output at any given price level. When the cost of resources goes up, profits
    fall, and the aggregate supply curve shifts to the left, from AS0 to AS2. Here, at any
    given level of price, firms produce less output.
    Remember that the vertical axis of the aggregate supply graph plots the price
    level for all goods and services produced in the economy. Only those changes in resource prices that raise the costs of production across the economy have an impact
    on the aggregate supply curve. For example, oil is an important raw material. If a
    new source of oil is discovered, the price of oil falls, and aggregate supply increases.
    However, if oil-exporting countries restrict oil supplies, and the price of oil increases
    substantially, aggregate supply decreases—a situation that occurred when OPEC
    reduced the supply of oil in the 1970s (see the Global Business Insight “OPEC and
    Aggregate Supply”). If the price of only one minor resource changed, then aggregate supply would be unlikely to change. For instance, if the price of land increased
    in Las Cruces, New Mexico, we would not expect the U.S. aggregate supply curve
    to be affected.
    4.c.2. Technology Technological innovations allow businesses to increase the
    productivity of their existing resources. As new technology is adopted, the amount
    of output that can be produced by each unit of input increases, moving the aggregate supply curve to the right. For example, personal computers and word-processing

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    267

    Figure 13
    Determinants of Aggregate Supply
    (a) Resource Prices (b) Technology (c) Expectations

    (a) Resource Prices

    Resource Prices
    Rise (Fall)

    Firms Decrease (Increase)
    Quantities Produced at
    Each Price Level

    Aggregate Supply
    Decreases (Increases)

    Output Produced per
    Unit of Input Increases

    Aggregate Supply
    Increases

    Wages and Other
    Resource Prices Rise

    Aggregate Supply
    Decreases

    (b) Technology

    Technology Improves

    (c) Expectations

    Higher Future Price
    Level Expected

    software have allowed secretaries to produce much more output in a day than typewriters allowed.
    4.c.3. Expectations To understand how expectations can affect aggregate supply, consider the case of labor contracts. Manufacturing workers typically contract
    for a nominal wage on the basis of what they and their employers expect the future
    level of prices to be. Because wages typically are set for at least a year, any unexpected increase in the price level during the year lowers real wages. Firms receive
    higher prices for their output, but the cost of labor stays the same. So profits and
    production go up.
    If wages rise in anticipation of higher prices, but prices do not go up, the cost of
    labor rises. Higher real wages caused by expectations of higher prices reduce current profits and production, moving the aggregate supply curve to the left. Other
    things being equal, anticipated higher prices cause aggregate supply to decrease;
    conversely, anticipated lower prices cause aggregate supply to increase. In this

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    Part Three / The National and Global Economies

    Figure 14

    LRAS

    LRAS 1

    Yp

    Yp1

    Changes in technology and
    the availability and quality of
    resources can shift the LRAS
    curve. For instance, a new
    technology that increases
    productivity would move the
    curve to the right, from LRAS
    to LRAS1.

    Price Level

    Shifting the Long-Run
    Aggregate Supply Curve

    Real GDP

    sense, expectations of price-level changes that shift aggregate supply bring about
    price-level changes.
    4.c.4. Economic Growth: Long-Run Aggregate Supply Shifts The vertical
    long-run aggregate supply curve, as shown in Figure 11, does not mean that the
    economy is forever fixed at the current level of potential real gross domestic product.
    Over time, as new technologies are developed, and the quantity and quality of resources increase, potential output also increases, shifting both the short- and longrun aggregate supply curves to the right. Figure 14 shows long-run economic
    growth by the shift in the aggregate supply curve from LRAS to LRAS1. The movement of the long-run aggregate supply curve to the right reflects the increase in potential real GDP from Yp to Yp1. Even though the price level has no effect on the
    level of output in the long run, changes in the determinants of the supply of real
    output in the economy do.

    R E C A P

    1. The aggregate supply curve shows the quantity of output (real GDP) produced at different price levels.
    2. The aggregate supply curve slopes up because, everything else held constant,
    higher prices increase producers’ profits, creating an incentive to increase
    output.
    3. The aggregate supply curve shifts with changes in resource prices, technology, and expectations. These are nonprice determinants of aggregate supply.
    4. The short-run aggregate supply curve is upward sloping, showing that
    increases in production are accompanied by higher prices.
    5. The long-run aggregate supply curve is vertical at potential real GDP
    because, eventually, wages and the costs of other resources adjust fully to
    price-level changes.

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    269

    Global Business Insight

    OPEC and Aggregate Supply

    270

    can see this in the
    graph. When the
    price of oil goes up,
    the aggregate supply
    curve falls from AS1
    to AS2. When aggregate supply falls, the
    equilibrium level of
    real GDP (the interP2
    section of the AS
    P1
    curve and the AD
    curve) falls from Y1
    to Y2.
    Higher oil prices
    due to restricted oil
    output would decrease not only
    short-run aggregate
    supply and current
    equilibrium real GDP,
    as shown in the figure, but also potential equilibrium income at the
    natural rate of unemployment.
    Unless other factors change to
    contribute to economic growth, the
    higher resource (oil) price reduces
    the productive capacity of the
    economy.
    There is evidence that fluctuations in oil prices have less effect on
    the economy today than in the past.†
    The amount of energy that goes into
    producing a dollar of GDP has declined over time so that oil plays a
    less important role as a determinant
    of aggregate supply today than in
    the 1970s and earlier. This means
    that any given change in oil prices
    today will be associated with
    smaller shifts in
    the AS curve than
    it would have
    been in earlier
    decades.
    While we have
    focused on the AS
    curve and oil
    prices, more

    AS 2
    AS 1

    Price Level

    I

    n the late winter of 2003, there
    was much talk about high oil
    prices leading to a fall in GDP for
    oil-importing countries. At the same
    time that the Bush administration
    was planning to invade Iraq, a move
    which would disrupt oil supplies
    from the Mideast, a strike by
    Venezuelan oil workers interrupted
    oil supplies from the world’s fifthlargest producer. Oil prices rose dramatically, and the price of gasoline
    rose from about $1.60 per gallon to
    more than $2 per gallon. The higher
    oil prices rose, the more talk there
    was about recession. What is the
    link between oil prices and real
    GDP? A look back to recent history
    can help develop our understanding
    of this link.
    In 1973 and 1974, and again in
    1979 and 1980, the Organization of
    Petroleum Exporting Countries
    (OPEC) reduced the supply of oil,
    driving the price of oil up dramatically. For example, the price of Saudi
    Arabian crude oil more than tripled
    between 1973 and 1974, and more
    than doubled between 1979 and
    1980. Researchers estimate that the
    rapid jump in oil prices reduced
    output by 17 percent in Japan, by
    7 percent in the United States, and
    by 1.9 percent in Germany.*
    Oil is an important resource in
    many industries. When the price of
    oil increases due to restricted oil
    output, aggregate supply falls. You

    AD
    Y2 Y1
    Real GDP
    recently, the AD curve has entered
    the discussion. Unlike earlier
    episodes, where oil price rises were
    the result of restricting the supply of
    oil, in the mid-2000s, the price of oil
    was being driven higher by rising demand—particularly from China and
    the United States.‡ If greater
    demand for oil persists, then it is
    unlikely that the price of oil will fall
    as quickly as it did in the earlier
    supply-driven episodes once supply
    increased.
    *These estimates were taken from “Energy Price Shocks, Aggregate Supply, and
    Monetary Policy: The Theory and the International Evidence,” Robert H. Rasche
    and John A. Tatom, in CarnegieRochester Conference Series on Public
    Policy, ed. Karl Brunner and Allan H.
    Meltzer, no. 14, Spring 1981, pp. 9–93.


    See Stephen P. A. Brown and Mine K.
    Yücel, “Oil Prices and the Economy,” in
    Southwest Economy, Federal Reserve
    Bank of Dallas, July–August 2000.



    See Christopher J. Neely, “Will Oil Prices
    Choke Growth,” Federal Reserve Bank of
    St. Louis, International Economic Trends,
    July 2004.

    Part Three / The National and Global Economies

    ?
    7. What determines the
    equilibrium price level
    and real GDP?

    5. AGGREGATE DEMAND AND SUPPLY EQUILIBRIUM
    Now that we have defined the aggregate demand and aggregate supply curves
    separately, we can put them together to determine the equilibrium level of price and
    real GDP.

    5.a. Short-Run Equilibrium
    Figure 15 shows the level of equilibrium in a hypothetical economy. Initially, the
    economy is in equilibrium at point 1, where AD1 and AS1 intersect. At this point,
    the equilibrium price is P1 and the equilibrium real GDP is $500. At price P1, the
    amount of output demanded is equal to the amount supplied. Suppose aggregate
    demand increases from AD1 to AD2. In the short run, aggregate supply does not
    change, so the new equilibrium is at the intersection of the new aggregate demand
    curve AD2 and the same aggregate supply curve AS1, at point 2. The new equilibrium
    price is P2, and the new equilibrium real GDP is $600. Note that in the short run,
    the equilibrium point on the short-run aggregate supply curve can lie to the right
    of the long-run aggregate supply curve (LRAS). This is because the LRAS represents the potential level of real GDP, not the capacity level. It is possible to produce
    more than the potential level of real GDP in the short run when the unemployment
    rate falls below the natural rate of unemployment.

    Figure 15
    Aggregate Demand and Supply Equilibrium
    The equilibrium level of price and real GDP is at the intersection of the AD and AS curves. Initially, equilibrium
    occurs at point 1, where the AD1 and AS1 curves intersect.
    Here the price level is P1 and real GDP is $500. If aggregate demand increases, moving from AD1 to AD2, in the
    short run there is a new equilibrium at point 2, where
    AD2 intersects AS1. The price level rises to P2, and the
    equilibrium level of real GDP increases to $600. Over
    time, as the costs of wages and other resources rise in

    response to higher prices, aggregate supply falls, moving
    AS1 to AS2. Final equilibrium occurs at point 3, where the
    AS2 curve intersects the AD2 curve. The price level rises to
    P3, but the equilibrium level of real GDP returns to its
    initial level, $500. In the long run, there is no relationship
    between prices and the equilibrium level of real GDP
    because the costs of resources adjust to changes in the
    level of prices.

    LRAS

    Price Level

    AS 2
    P3

    AS 1

    3

    P2

    2

    P1

    1

    AD 2
    AD 1

    0

    100

    200

    300

    400

    500

    600

    700

    Real GDP (dollars)

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    271

    Now You Try It

    foreign price levels rise?
    foreign incomes fall?
    taxes rise?
    the use of new computers
    increases productivity?

    Point 2 is not a permanent equilibrium because aggregate supply decreases to
    AS2 once the costs of production rise in response to higher prices. Final equilibrium is at point 3, where the price level is P3 and real GDP is $500. Notice that
    equilibrium here is the same as the initial equilibrium at point 1. Points 1 and 3
    both lie along the long-run aggregate supply curve (LRAS). The initial shock to
    or change in the economy was an increase in aggregate demand. The change in
    aggregate expenditures initially led to higher output and higher prices. Over
    time, however, as resource costs rise and profit falls, output falls back to its
    original value.
    We are not saying that the level of output never changes. The long-run aggregate
    supply curve shifts as technology changes, and new supplies of resources are
    obtained. But the output change that results from a change in aggregate demand is
    a temporary, or short-run, phenomenon. The price level eventually adjusts, and output eventually returns to the potential level.

    R E C A P

    1. The equilibrium level of price and real GDP is at the point where the aggregate demand and aggregate supply curves intersect.
    2. In the short run, a shift in aggregate demand establishes a temporary equilibrium along the short-run aggregate supply curve.
    3. In the long run, the short-run aggregate supply curve shifts so that changes in
    aggregate demand only affect the price level, not the equilibrium level of output or real GDP.

    What will happen to the equilibrium price level and real
    GDP when:
    1.
    2.
    3.
    4.

    5.b. Long-Run Equilibrium

    SUMMARY
    ?

    1.
    2.

    3.

    What is aggregate demand?

    Aggregate demand is the relation between aggregate
    expenditures and the price level.
    Aggregate demand is the sum of consumption, investment, government spending, and net exports at alternative price levels.
    Aggregate expenditures change with changes in the
    price level because of the wealth effect, the interest
    rate effect, and the international trade effect. These
    cause a movement along the AD curve.

    ?

    7.

    ?

    8.

    ?
    ?

    4.
    5.
    6.

    272

    What causes the aggregate demand curve to
    shift?

    The aggregate demand (AD) curve shows the level of
    expenditures for real GDP at different price levels.
    Because expenditures and prices move in opposite directions, the AD curve is negatively sloped.
    The nonprice determinants of aggregate demand include expectations, foreign income and price levels,
    and government policy.

    9.

    ?

    What is aggregate supply?

    Aggregate supply is the relation between the quantity
    of real GDP produced and the price level.
    Why does the short-run aggregate supply curve
    become steeper as real GDP increases?

    As real GDP rises, and the economy pushes closer to
    capacity output, the level of prices must rise to induce
    increased production.
    Why is the long-run aggregate supply curve
    vertical?

    The long-run aggregate supply curve is vertical at the
    potential level of real GDP because there is no effect
    of higher prices on output when an economy is producing at potential real GDP.
    What causes the aggregate supply curve to shift?

    10. The nonprice determinants of aggregate supply are resource prices, technology, and expectations.

    Part Three / The National and Global Economies

    ?

    What determines the equilibrium price level and
    real GDP?

    11. The equilibrium level of price and real GDP is at the
    intersection of the aggregate demand and aggregate
    supply curves.

    12. In the short run, a shift in aggregate demand establishes a new, but temporary, equilibrium along the
    short-run aggregate supply curve.
    13. In the long run, the short-run aggregate supply curve
    shifts so that changes in aggregate demand determine
    the price level, not the equilibrium level of output or
    real GDP.

    EXERCISES
    1.

    How is the aggregate demand curve different from the
    demand curve for a single good, like hamburgers?
    2. Why does the aggregate demand curve slope down?
    Give real-world examples of the three effects that
    explain the slope of the curve.
    3. How does an increase in foreign income affect domestic aggregate expenditures and demand? Draw a diagram to illustrate your answer.
    4. How does a decrease in foreign price levels affect
    domestic aggregate expenditures and demand? Draw
    a diagram to illustrate your answer.
    5. How is the aggregate supply curve different from the
    supply curve for a single good, like pizza?
    6. There are several determinants of aggregate supply
    that can cause the aggregate supply curve to shift.
    a. Describe those determinants and give an example
    of a change in each.
    b. Draw and label an aggregate supply diagram that illustrates the effect of the change in each determinant.
    7. Draw a short-run aggregate supply curve that gets
    steeper as real GDP rises.
    a. Explain why the curve has this shape.
    b. Now draw a long-run aggregate supply curve that
    intersects a short-run AS curve. What is the relationship between short-run AS and long-run AS?
    8. Draw and carefully label an aggregate demand and
    supply diagram with initial equilibrium at P0 and Y0.
    a. Using the diagram, explain what happens when aggregate demand falls.
    b. How is the short run different from the long run?
    9. Draw an aggregate demand and supply diagram for
    Japan. In the diagram, show how each of the following affects aggregate demand and supply:
    a. U.S. gross domestic product falls.
    b. The level of prices in Korea falls.
    c. Labor receives a large wage increase.
    d. Economists predict higher prices next year.
    10. If the long-run aggregate supply curve gives the level
    of potential real GDP, how can the short-run aggregate supply curve ever lie to the right of the long-run
    aggregate supply curve?

    11. What will happen to the equilibrium price level and
    real GDP if:
    a. Aggregate demand and aggregate supply both
    increase?
    b. Aggregate demand increases and aggregate supply
    decreases?
    c. Aggregate demand and aggregate supply both
    decrease?
    d. Aggregate demand decreases and aggregate supply
    increases?
    12. During the Great Depression, the U.S. economy experienced a falling price level and declining real
    GDP. Using an aggregate demand and aggregate supply diagram, illustrate and explain how this could
    occur.
    13. Suppose aggregate demand increases, causing an increase in real GDP but no change in the price level.
    Using an aggregate demand and aggregate supply diagram, illustrate and explain how this could occur.
    14. Suppose aggregate demand increases, causing an increase in the price level but no change in real GDP.
    Using an aggregate demand and aggregate supply diagram, illustrate and explain how this could occur.
    15. Use an aggregate demand and aggregate supply diagram
    to illustrate and explain how each of the following will
    affect the equilibrium price level and real GDP:
    a. Consumers expect a recession.
    b. Foreign income rises.
    c. Foreign price levels fall.
    d. Government spending increases.
    e. Workers expect higher future inflation and negotiate higher wages now.
    f. Technological improvements increase productivity.
    16. In the boom years of the late 1990s, it was often said
    that rapidly increasing stock prices were responsible
    for much of the rapid growth of real GDP. Explain
    how this could be true by using aggregate demand and
    aggregate supply analysis.
    17. In 2003, there was much concern that rising oil prices
    would contribute to a global recession. Use aggregate
    demand and supply analysis to explain how high oil
    prices could reduce real GDP.

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    273

    Internet
    Exercise

    274

    The length of expansions and contractions in the business cycle is determined by the
    size and duration of shifts in aggregate demand (AD) and aggregate supply (AS).
    Check out the history of U.S. business cycle fluctuations by going to the Boyes/Melvin
    Fundamentals of Economics website accessible through http://college.hmco.com/
    pic/boyesfund4e and clicking on the Internet Exercise link for Chapter 12. Now
    answer the questions found on the Boyes/Melvin website.

    Part Three / The National and Global Economies

    Study Guide for Chapter 12
    Key Term Match

    3

    Which of the following will not cause an increase in
    U.S. exports?
    ■ a. European incomes increase.
    ■ b. The dollar depreciates.
    ■ c. A favorable change in tastes
    ■ d. The dollar appreciates.
    ■ e. A meeting of the WTO results in lowered trade
    restrictions.

    4

    Which of the following will not decrease U.S. aggregate demand?

    Match each term with its correct definition by placing the appropriate letter next to the corresponding
    number.
    A.
    B.
    C.
    D.
    E.
    F.

    wealth effect
    interest rate effect
    international trade effect
    aggregate demand curve
    aggregate supply curve
    long-run aggregate supply curve (LRAS)
    1. a curve that shows the different levels of
    expenditures on domestic output at different
    levels of prices
    2. a vertical line at the potential level of national
    income
    3. a change in the real value of wealth that causes
    spending to change when the level of prices
    changes
    4. a curve that shows the amount of real GDP
    produced at different price levels
    5. a change in interest rates that causes investment
    and therefore aggregate expenditures to change as
    the level of prices changes
    6. a change in aggregate expenditures resulting from
    a change in the domestic price level that changes
    the price of domestic goods in relation to foreign
    goods

    ■ a. Consumers expect a recession.
    ■ b. The dollar depreciates.
    ■ c. Mexican and Canadian incomes decline.
    ■ d. The cost of capital goods increases.
    ■ e. Excess capacity in manufacturing becomes
    apparent.
    5

    money. They
    bonds, causing interest rates to
    and aggregate expenditures to
    ■ a. more; buy; fall; rise
    ■ b. more; sell; rise; fall
    ■ c. more; sell; fall; rise
    ■ d. less; buy; fall; rise
    ■ e. more; buy; rise; fall

    Which of the following would cause an increase in
    both the equilibrium price level and the equilibrium
    level of real GDP?
    ■ a. The Fed cuts interest rates.
    ■ b. Business confidence decreases.
    ■ c. Energy prices decrease.
    ■ d. Energy prices increase.
    ■ e. Interest rates fall accompanied by a decline in
    energy prices.

    2

    Which of the following will not decrease investment?
    ■ a. an increase in the cost of capital goods
    ■ b. an improvement in technology
    ■ c. an increase in interest rates
    ■ d. unfavorable changes in tax policy
    ■ e. rumors that the government will nationalize
    firms

    .

    6

    The long-run aggregate supply curve is
    ■ a. upward-sloping because of the effect of higher
    prices on profits.
    ■ b. horizontal, reflecting excess capacity in all parts
    of the economy.
    ■ c. upward-sloping, reflecting excess capacity in
    some parts of the economy.
    ■ d. horizontal because there is no relationship
    between the price level and national income in
    the long run.
    ■ e. vertical because there is no relationship between
    the price level and national income in the long
    run.

    7

    Which of the following statements is false?
    ■ a. The long-run aggregate supply curve can shift
    to the right if new technologies are developed.
    ■ b. The long-run aggregate supply curve can shift
    to the left if the quality of the factors of
    production decreases.
    ■ c. The long-run aggregate supply curve is fixed at
    potential output and cannot shift.

    Quick-Check Quiz
    1

    When prices increase, people and businesses need

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    275

    ■ d. An increase in long-run aggregate supply will
    decrease the equilibrium price level.
    ■ e. A decrease in long-run aggregate supply will
    decrease the equilibrium level of real GDP.
    8

    9

    Which of the following will increase aggregate
    supply?
    ■ a. Oil prices increase as Saudi Arabia decreases its
    production.
    ■ b. A change in computer chip technology
    increases productivity.
    ■ c. The Consumer Price Index rises.
    ■ d. The price level decreases.
    ■ e. Consumers anticipate higher prices.
    Consumer prices rose at their fastest rate in a year in
    January 2004, fueled mostly by higher energy prices.
    This increase in inflation coupled with an increase in
    unemployment can only result from a(n)
    ■ a. increase in aggregate demand.
    ■ b. decrease in aggregate demand.
    ■ c. increase in aggregate supply.
    ■ d. decrease in aggregate supply.
    ■ e. decrease in government spending.

    10 Which of the following statements is true?

    ■ a. In the long run, the short-run aggregate demand

    ■ b.

    ■ c.
    ■ d.
    ■ e.

    curve shifts so that changes in aggregate supply
    determine the price level, not the equilibrium
    level of income.
    In the long run, the short-run aggregate demand
    curve shifts so that changes in aggregate supply
    determine the equilibrium level of income, not
    the price level.
    In the long run, the equilibrium level of output
    never changes.
    In the long run, there is a positive relationship between the level of prices and the level of output.
    In the long run, the short-run aggregate supply
    curve shifts so that changes in aggregate
    demand determine the price level, not the
    equilibrium level of income.

    3

    unemployment

    (rises, falls),

    and the price level

    (rises, falls).

    A(n)
    (increase, decrease) in
    aggregate supply leads to an increase in the equilibrium level of national income, a(n)
    (increase, decrease) in unemployment, and a(n)
    (increase, decrease) in the
    price level.

    4

    inflation is an increase in the
    price level caused by increased costs of production.

    5

    If wealth decreases, consumption (spending by households)

    .

    6

    As foreign income rises, net exports

    7

    If a new trade agreement with Japan succeeds in opening Japanese markets to U.S. goods, net exports will

    .

    .
    8

    equal exports minus imports.

    9

    All other things being equal, economists expect consumption to
    change) as the population increases.

    (rise, fall, not

    10 As taxation increases, consumption

    (rises, falls, does not change).
    11

    is business spending on capital goods and inventories.

    12 As

    household

    wealth

    increases,

    consumption

    (increases, decreases).
    13 List the five determinants of consumption.

    Practice Questions and Problems
    1

    2

    inflation is inflation caused
    by increasing demand for output.
    If aggregate demand falls, the equilibrium level
    of income

    276

    (rises, falls),

    14 As the cost of capital goods rises, the amount of in-

    vestment

    (rises, falls).

    15 When capacity utilization is high, investment tends to

    (rise, fall).

    Part Three / The National and Global Economies

    16 List the four determinants of investment.

    25 Higher foreign incomes cause

    to rise, causing
    (a movement
    along the aggregate demand curve, a shift in aggregate
    demand to the right).
    17 When the domestic currency depreciates, imports

    26 If the prices of output increase while all other

    prices remain unchanged, business profits will

    (rise, fall).

    (increase, decrease), and

    18 The higher the domestic income, the

    producers will produce
    (more, less) output.

    (higher, lower) the net exports.
    19 List the four determinants of net exports.

    27 List the three nonprice determinants of short-run ag-

    gregate supply.

    20 As the level of prices increases, the purchasing power

    of money

    (increases, de28 When the prices of resources fall, the short-run aggregate

    creases), and the real value of assets
    (increases, decreases). The
    effect, or real-balance effect, predicts that the
    real value of aggregate expenditures will then

    supply curve shifts to the

    .

    29 In the long run, there

    (is, is
    not) a relationship between the level of prices and the
    level of output.

    (rise, fall).
    21 If domestic prices rise while foreign prices and for-

    eign exchange rates remain constant, domestic goods
    will become
    (less expensive,
    more expensive) for foreigners. Net exports will
    (rise, fall), causing aggregate
    expenditures to
    22 If

    (rise, fall).

    foreign prices fall, foreign goods become
    (less expensive, more expen-

    sive), which causes
    (a movement along the aggregate demand curve, a shift to the
    left of the aggregate demand curve).
    23 A

    fall

    in

    the

    domestic

    price

    level

    causes

    (a movement along the aggregate demand curve, a shift in aggregate demand to
    the left).
    24 Positive expectations about the economy increase

    and
    which in turn
    creases) aggregate demand.

    ,
    (increases, de-

    Exercises and Applications
    I

    Aggregate Demand and Its Determinants Now
    that you have finished this chapter, you should be
    able to predict the effect on aggregate demand when
    one of its determinants changes. In the following exercise, decide which of the spending components each
    event affects, whether it increased or decreased the
    component, and whether it increased or decreased
    aggregate demand. Remember the determinants of
    each component of aggregate demand:

    Consumption: income, wealth, expectations, demographics, taxes
    Investment: interest rate, cost of capital goods,
    technology, capacity utilization
    Government spending: set by government authorities
    Net exports: foreign and domestic income and prices,
    exchange rates, government policy
    Events
    1. The Federal Reserve, fearing an upsurge in
    inflation, increases interest rates.

    Chapter 12 / Macroeconomic Equilibrium: Aggregate Demand and Supply

    277

    2. In the wake of the war in Iraq, the dollar depreciates against the euro.
    3. In April 2004, Fed Chairman Alan Greenspan
    opposed a tax increase to contain the deficit and
    instead proposed scaling back on social security
    and Medicare. Consider the effects if Greenspan’s
    recommendations are implemented by Congress.

    Component
    1. Investment

    II

    4. Foreign incomes rise.
    5. The population increases more quickly.
    6. Factories note a decline in the rate of capacity
    utilization.
    7. Congress imposes a nationwide sales tax on retail
    goods and services.
    8. The cost of capital goods decreases.

    Effect on Component
    Decrease

    Effect on Aggregate Demand
    Decrease

    2.





    3.





    4.





    5.





    6.





    7.





    8.









    A Long-Run Analysis of the Effects of a Slump in
    Productivity Many people have been concerned

    about the slower growth of productivity in recent
    years. Suppose that the growth of productivity in the
    United States not only slows but actually decreases.
    This could result from declines in workers’ basic
    skills that some educators believe are due to a lack of
    students’ adequate preparation in the nation’s high
    schools. What will happen to the equilibrium price
    level and real GDP in the long run? Use the graph at
    right to analyze this problem. Be sure to label your
    axes.

    ACE s

    ✸✔

    278

    -test
    elf

    Now that you’ve completed the Study Guide for this
    chapter, you should have a good sense of the concepts
    you need to review. If you’d like to test your understanding of the material again, go to the Practice Tests
    on the Boyes/Melvin Fundamentals of Economics, 4e
    website, http://college.hmco.com/pic/boyesfund4e.

    Part Three / The National and Global Economies

    This page intentionally left blank

    Chapter 13

    ?

    Fundamental
    Questions

    1. How can fiscal policy
    eliminate a GDP gap?
    2. How has U.S. fiscal
    policy changed over
    time?
    3. What are the effects
    of budget deficits?
    4. How does fiscal
    policy differ across
    countries?

    280

    Fiscal Policy

    M

    acroeconomics plays a key role in national politics. When Jimmy Carter ran
    for the presidency against Gerald Ford in
    1976, he created a “misery index” to measure the state of the economy. The index
    was the sum of the inflation rate and the unemployment rate, and Carter showed
    that it had risen during Ford’s term in office. When Ronald Reagan challenged
    Carter in 1980, he used the misery index to show that inflation and unemployment
    had gone up during the Carter years. The implication is that presidents are responsible for the condition of the economy. If the inflation rate or the unemployment
    rate is relatively high coming into an election year, incumbent presidents are open
    to criticism by their opponents. For instance, many people believe that George
    Bush was defeated by Bill Clinton in 1992 because of the country’s economic
    conditions. Clinton emphasized the recession that began in 1990—a recession that
    was not announced as having ended in March 1991 until after the election. As a
    result, Clinton’s campaign made economic growth a focus of its attacks on Bush.
    Then in 1996, a healthy economy helped Bill Clinton defeat Bob Dole. In the
    election of 2000, Al Gore supporters made the strong economic growth during the
    Clinton years a major focal point of their campaign against George W. Bush.
    Finally, in 2004, the Bush administration was criticized for a lack of job growth,
    even though the economy was growing. This is more than campaign rhetoric,
    however. By law the government is responsible for the macroeconomic health of
    the nation. The Employment Act of 1946 states:
    “It is the continuing policy and responsibility of the Federal Government to use
    all practical means consistent with its needs and obligations and other essential
    considerations of national policy to coordinate and utilize all its plans, functions,
    and resources for the purpose of creating and maintaining, in a manner calculated
    to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment for those able, willing, and seeking to work, and to promote
    maximum employment, production, and purchasing power.”
    Fiscal policy is one tool that government uses to guide the economy along
    an expansionary path. In this chapter we examine the role of fiscal policy—government
    spending and taxation—in determining the equilibrium level of income. Then we

    Preview

    Part Three / The National and Global Economies

    review the budget process and the history of fiscal policy in the United States.
    Finally, we describe the difference in fiscal policy between industrial and developing countries. ■

    ?
    1. How can fiscal policy
    eliminate a GDP gap?

    1. FISCAL POLICY AND AGGREGATE DEMAND
    The GDP gap is the difference between potential real GDP and the equilibrium
    level of real GDP. If the government wants to close the GDP gap so that the equilibrium level of real GDP reaches its potential, it must use fiscal policy to alter aggregate expenditures and cause the aggregate demand curve to shift.
    Fiscal policy is the government’s policy with respect to spending and taxation.
    Since aggregate demand includes consumption, investment, net exports, and government spending, government spending on goods and services affects the level of
    aggregate demand directly. Taxes affect aggregate demand indirectly by changing
    the disposable income of households, which alters consumption.

    1.a. Shifting the Aggregate Demand Curve
    Changes in government spending and taxes shift the aggregate demand curve. Remember that the aggregate demand curve represents combinations of equilibrium
    aggregate expenditures and alternative price levels. An increase in government
    spending or a decrease in taxes raises the level of expenditures at every level of
    prices and moves the aggregate demand curve to the right.
    Figure 1 shows an increase in aggregate demand that would result from an increase
    in government spending or a decrease in taxes. Only if the aggregate supply curve is
    horizontal do prices remain fixed as aggregate demand increases. In Figure 1(a), equilibrium occurs along the horizontal segment (the Keynesian region) of the AS
    curve. If government spending increases, and the price level remains constant, aggregate demand shifts from AD to AD1; it increases by the horizontal distance from
    point A to point B. Once aggregate demand shifts, the AD1 and AS curves intersect
    at potential real GDP, Yp.
    But Figure 1(a) is not realistic. The AS curve is not likely to be horizontal all the
    way to the level of potential real GDP; it should begin sloping up well before Yp.
    And once the economy reaches the capacity level of output, the AS curve should
    become a vertical line, as shown in Figure 1(b).
    If the AS curve slopes up before reaching the potential real GDP level, as it does
    in part (b) of the figure, expenditures have to go up by more than the amount suggested in part (a) for the economy to reach Yp. Why? Because when prices rise, the
    effect of spending on real GDP is reduced. This effect is shown in Figure 1(b). To increase the equilibrium level of real GDP from Ye to Yp, aggregate demand must shift
    by the amount from point A to C, a larger increase than that shown in Figure 1(a),
    where the price level is fixed.

    1.b. Multiplier Effects
    Changes in government spending may have an effect on real GDP that is a multiple of
    the original change in government spending; a $1 change in government spending
    may increase real GDP by more than $1. This is because the original $1 of expenditure
    is spent over and over again in the economy as it passes from person to person. The
    government spending multiplier measures the multiple by which an increase in government spending increases real GDP. Similarly, a change in taxes may have an effect
    on real GDP that is a multiple of the original change in taxes.
    If the price level rises as real GDP increases, the multiplier effects of any
    given change in aggregate demand are smaller than they would be if the price
    Chapter 13 / Fiscal Policy

    281

    Eliminating the
    Recessionary Gap: Higher
    Prices Mean Greater
    Spending

    AS
    A

    B

    AD 1

    AD
    Ye

    Yp

    Real GDP

    (b) Aggregate Demand and Supply
    (rising prices in intermediate range of AS curve)

    AS
    A

    C

    Price Level

    When aggregate demand increases from AD to AD1 in
    Figure 1(a), equilibrium real
    GDP increases by the full
    amount of the shift in demand. This is because the aggregate supply curve is horizontal over the area of the
    shift in aggregate demand. In
    Figure 1(b), in order for equilibrium real GDP to rise from
    Ye to Yp , aggregate demand
    must shift by more than it
    does in part (a). In reality, the
    aggregate supply curve begins to slope up before potential real GDP (Yp ) is
    reached, as shown in part (b)
    of the figure.

    (a) Aggregate Demand and Supply
    (constant prices in Keynesian range of AS curve)

    Price Level

    Figure 1

    AD 1

    AD
    Ye

    Yp

    Real GDP

    level remains constant. In addition to changes in the price level modifying the effect of government spending and taxes on real GDP, there are other factors that
    affect how much real GDP will change following a change in government spending. One such factor is how the government pays for, or finances, its spending.
    Government spending must be financed by some combination of taxing, borrowing, or creating money:
    Government spending  taxes  change in government debt
     change in government-issued money
    In Chapter 15 we discuss the effect of financing government spending by creating money. As you will see, this source of government financing is relied on
    heavily in some developing countries. Here we talk about the financing problem
    relevant for industrial countries: how taxes and government debt can modify the
    expansionary effect of government spending on national income.

    1.c. Government Spending Financed by Tax Increases
    Suppose that government spending rises by $100 billion and that this expenditure is financed by a tax increase of $100 billion. Such a “balanced-budget”
    change in fiscal policy will cause equilibrium real GDP to rise. This is because

    282

    Part Three / The National and Global Economies

    government spending increases aggregate expenditures directly, but higher taxes
    lower aggregate expenditures indirectly through consumption spending. For instance, if taxes increase $100, consumers will not cut their spending by $100,
    but by some fraction, say 9/10, of the increase. If consumers spend 90 percent of
    a change in their disposable income, then a tax increase of $100 would lower
    consumption by $90. So the net effect of raising government spending and taxes
    by the same amount is an increase in aggregate demand, illustrated in Figure 2
    as the shift from AD to AD1. However, it may be incorrect to assume that the
    only thing that changes is aggregate demand. An increase in taxes may also affect aggregate supply.
    Aggregate supply measures the output that producers offer for sale at different
    levels of prices. When taxes go up, workers have less incentive to work because
    their after-tax income is lower. The cost of taking a day off or extending a vacation
    for a few extra days is less than it is when taxes are lower and after-tax income is
    higher. When taxes go up, then, output can fall, causing the aggregate supply curve
    to shift to the left. Such supply-side effects of taxes have been emphasized by the
    so-called supply-side economists.
    Figure 2 shows the possible effects of an increase in government spending financed by taxes. The economy is initially in equilibrium at point A, with prices
    at P1 and real GDP at Y1. The increase in government spending shifts the aggregate demand curve from AD to AD1. If this were the only change, the economy
    would be in equilibrium at point B. But if the increase in taxes reduces output,
    the aggregate supply curve moves back from AS to AS1, and output does not expand all the way to Yp. The decrease in aggregate supply creates a new equilibrium at point C. Here real GDP is at Y2 (less than Yp), and the price level is P3
    (higher than P2).
    The standard analysis of government spending and taxation assumes that aggregate supply is not affected by the change in fiscal policy, leading us to expect a
    greater change in real GDP than may actually occur. If tax changes do affect aggregate supply, the expansionary effects of government spending financed by tax increases are moderated. The actual magnitude of the effect is the subject of debate
    among economists. Most argue that the evidence in the United States indicates that
    tax increases have a fairly small effect on aggregate supply.

    Figure 2

    AS 1

    The Effect of Taxation on
    Aggregate Supply

    C

    P3
    Price Level

    An increase in government
    spending shifts the aggregate
    demand curve from AD to
    AD1, moving equilibrium from
    point A to point B, and equilibrium real GDP from Y1 to
    Yp . If higher taxes reduce the
    incentive to work, aggregate
    supply could fall from AS to
    AS1, moving equilibrium to
    point C and equilibrium real
    GDP to Y2, a level below potential real GDP.

    AS

    B

    P2
    A
    P1

    AD 1
    AD
    0

    Y1 Y2 Yp
    Real GDP

    Chapter 13 / Fiscal Policy

    283

    Many government expenditures
    are unrelated to current economic conditions. For instance,
    the provision of national defense,
    a legal system, and police and
    fire protection are all cases in
    which government expenditures
    would not typically fluctuate with
    the business cycle. These firefighters are employed through
    booms and recessions in the
    economy. Although macroeconomists focus typically on the
    discretionary elements of fiscal
    policy that may be altered to
    combat business cycles, the
    nondiscretionary elements
    account for the bulk of governments’ budgets.

    1.d. Government Spending Financed by Borrowing
    The standard multiplier analysis of government spending does not differentiate
    among the different methods of financing that spending. Yet you just saw how taxation can offset at least part of the expansionary effect of higher government spending. Borrowing to finance government spending can also limit the increase in aggregate demand.
    A government borrows funds by selling bonds to the public. These bonds represent debt that must be repaid at a future date. Debt is, in a way, a kind of substitute
    for current taxes. Instead of increasing current taxes to finance higher spending, the
    government borrows the savings of households and businesses. Of course, the debt
    will mature and have to be repaid. This means that taxes will have to be higher in
    the future in order to provide the government with the funds to pay off the debt.
    Current government borrowing, then, implies higher future taxes. This can limit
    the expansionary effect of increased government spending. If households and businesses take higher future taxes into account, they tend to save more today so that
    they will be able to pay those taxes in the future. And as saving today increases,
    consumption today falls.

    1.e. Crowding Out

    crowding out: a drop in
    consumption or investment
    spending caused by
    government spending

    284

    Expansionary fiscal policy can crowd out private-sector spending; that is, an increase in government spending can reduce consumption and investment.
    Crowding out is usually discussed in the context of government spending financed by borrowing rather than by taxing. Though we have just seen how future taxes can cause consumption to fall today, investment can also be affected.
    Increases in government borrowing drive up interest rates. As interest rates go
    up, investment falls. This sort of indirect crowding out works through the bond
    market. The U.S. government borrows by selling Treasury bonds or bills. Because the government is not a profit-making institution, it does not have to earn
    a profitable return from the money it raises by selling bonds. A corporation
    does, however. When interest rates rise, fewer corporations offer new bonds to
    raise investment funds because the cost of repaying the bond debt may exceed
    the rate of return on the investment.

    Part Three / The National and Global Economies

    Crowding out is important in principle, but economists have never demonstrated
    conclusively that its effects can substantially alter spending in the private sector.
    Still, you should be aware of the possibility to understand the potential shortcomings of changes in government spending and taxation.

    R E C A P

    1. Fiscal policy refers to government spending and taxation.
    2. By increasing spending or cutting taxes, a government can close the
    GDP gap.
    3. If government spending and taxes increase by the same amount, equilibrium
    real GDP rises.
    4. If a tax increase affects aggregate supply, then a balanced-budget change in
    fiscal policy will have a smaller expansionary effect on equilibrium real GDP
    than otherwise.
    5. Current government borrowing reduces current spending in the private sector
    if people increase current saving in order to pay future tax liabilities.
    6. Increased government borrowing can crowd private borrowers out of the
    bond market so that investment falls.

    2. FISCAL POLICY IN THE UNITED STATES
    Our discussion of fiscal policy assumes that policy is made at the federal level. In
    the modern economy this is a reasonable assumption. This was not the case before
    the 1930s, however. Before the Depression, the federal government limited its activities largely to national defense and foreign policy, and left other areas of government policy to the individual states. With the growth of the importance of the
    federal government in fiscal policy has come a growth in the role of the federal
    budget process.

    2.a. The Budget Process
    Fiscal policy in the United States is the product of a complex process that involves
    both the executive and legislative branches of government (Figure 3). The fiscal
    year for the U.S. government begins October 1 of one year and ends September 30
    of the next. The budget process begins each spring when the president directs the
    federal agencies to prepare their budgets for the fiscal year that starts almost
    18 months later. The agencies submit their budget requests to the Office of Management and Budget (OMB) by early September. The OMB reviews and modifies
    each agency’s request and consolidates all of the proposals into a budget that the
    president presents to Congress in January.
    Once Congress receives the president’s budget, the Congressional Budget Office
    (CBO) studies it, and committees modify it before funds are appropriated. The
    budget is evaluated in Budget Committee hearings in both the House of Representatives and the Senate. In addition, the CBO reports to Congress on the validity of
    the economic assumptions made in the president’s budget. A budget resolution is
    passed by April 15 that sets out major expenditures and estimated revenues. (Revenues are estimated because future tax payments can never be known exactly.) The
    resolution is followed by reconciliation, a process in which each committee of
    Congress must coordinate relevant tax and spending decisions. Once the reconciliation process is completed, funds are appropriated. The process is supposed to end
    before Congress recesses for the summer, at the end of June. When talking about
    the federal budget, the monetary amounts of various categories of expenditures are

    Chapter 13 / Fiscal Policy

    285

    Figure 3
    The Making of U.S. Fiscal Policy
    The flow chart shows the policymaking process. Start with
    the president and follow the arrows in order. Although

    the dates are approximate, the process of setting the federal budget involves these stages and participants.

    4 Presents Recommended Budget
    January

    President

    8 Appropriates Funds
    from June on

    Congress

    7

    nd
    me r
    om b e
    ec m
    t R ece
    ge D
    ud er–
    s B tob
    nd Oc

    5
    e
    dg
    Bu
    es ry
    yz a
    al bru
    An Fe

    io

    at
    ns

    6 Passes Budget Resolution
    April

    Se

    1 Solicits Budget Requests
    April

    3
    Congressional
    Budget Office
    (CBO)

    Re

    con
    Jun cilia
    e tion
    All
    Committees

    t

    Federal
    Agencies

    2 Submit Requests
    September

    ?
    2. How has U.S. fiscal
    policy changed over
    time?

    discretionary fiscal policy:
    changes in government
    spending and taxation aimed
    at achieving a policy goal
    automatic stabilizer: an
    element of fiscal policy that
    changes automatically as
    income changes

    286

    Office of
    Management
    and Budget
    (OMB)

    Budget
    Committees

    so huge that they are often difficult to comprehend. But if you were to divide up
    the annual budget by the number of individual taxpayers, you would come up
    with an average individual statement that might make more sense, as shown in the
    Economic Insight “The Taxpayer’s Federal Government Credit Card Statement.”
    The federal budget is determined as much by politics as by economics. Politicians respond to different groups of voters by supporting different government programs regardless of the needed fiscal policy. It is the political response to constituents that tends to drive up federal budget deficits (the difference between
    government expenditures and tax revenues), not the need for expansionary fiscal
    policy. As a result, deficits have become commonplace.

    2.b. The Historical Record
    The U.S. government has grown dramatically since the early part of the century.
    Figure 4 shows federal revenues and expenditures over time. Figure 5 places the
    growth of government in perspective by plotting U.S. government spending as a percentage of gross domestic product over time. Before the Great Depression, federal
    spending was approximately 3 percent of the GDP; by the end of the Depression, it
    had risen to almost 10 percent. The ratio of spending to GDP reached its peak during
    World War II, when federal spending hit 45 percent of the GDP. After the war, the
    ratio fell dramatically and then slowly increased to about 18 percent today.
    Fiscal policy has two components: discretionary fiscal policy and automatic stabilizers. Discretionary fiscal policy refers to changes in government spending and taxation aimed at achieving a policy goal. Automatic stabilizers are elements of fiscal
    policy that automatically change in value as national income changes. Figures 4 and
    5 suggest that government spending is dominated by growth over time. But there is

    Part Three / The National and Global Economies

    The Taxpayer’s Federal Government
    Credit Card Statement
    Suppose the U.S. government’s
    expenditures and revenues were
    accounted for annually to each
    individual income taxpayer like
    a credit card statement. For 2005,
    the statement would look like
    the one at the right.

    Economic Insight

    Statement for 2005 Budget Year
    Previous balance

    $60,745.08

    New purchases
    Department of Defense military
    Homeland security

    3,634.71
    230.53

    Social security

    3,988.20

    Medicare

    2,259.21

    Medicaid

    1,436.98

    Other programs

    6,032.24

    Total spending

    17,581.87

    Payments received
    Individual income and social
    security taxes
    Corporate income taxes
    Other
    Total payments
    Finance charge
    New balance due

    13,227.14
    2,138.56
    1,185.70
    16,551.40
    1,413.93
    63,189.48

    no indication here of discretionary changes in fiscal policy, changes in government
    spending and taxation aimed at meeting specific policy goals. Perhaps a better way to
    evaluate the fiscal policy record is in terms of the budget deficit. Government expenditures can rise, but the effect on aggregate demand could be offset by a simultaneous
    increase in taxes so that there is no expansionary effect on the equilibrium level of national income. By looking at the deficit, we see the combined spending and tax policy
    results that are missing if only government expenditures are considered.
    Figure 6 illustrates the pattern of the U.S. federal deficit and the deficit as a percentage of GDP over time. Figure 6(a) shows that the United States ran close to a
    balanced budget for much of the 1950s and 1960s. There were large deficits associated with financing World War II and then large deficits resulting from fiscal policy
    decisions in the 1970s, 1980s, and 1990s. By 1998, however, the first surplus since
    1969 was recorded. However, by 2002, budget deficits had returned. Figure 6(b)
    shows that the deficit as a percentage of GDP was much larger during World War II
    than in recent years.
    The deficit increase in the mid-1970s was a product of a recession that cut the
    growth of tax revenues. Historically, aside from wartime, budget deficits increase
    the most during recessions. When real GDP falls, tax revenues go down, and government spending on unemployment and welfare benefits goes up. These are examples of automatic stabilizers in action. As income falls, taxes fall and personal benefit payments rise to partially offset the effect of the drop in income. The rapid
    growth of the deficit in the 1980s involved more than the recessions in 1980 and
    1982, however. The economy grew rapidly after the 1982 recession ended, but so
    did the fiscal deficit. The increase in the deficit was the product of a rapid increase
    in government spending to fund new programs and enlarge existing programs
    while taxes were held constant. The reduction in the deficit in the late 1990s was

    Chapter 13 / Fiscal Policy

    287

    Figure 4

    2,500

    U.S. Government Revenues
    and Expenditures

    2,400

    Revenues are total revenues
    of the U.S. government in
    each fiscal year. Expenditures
    are total spending of the U.S.
    government in each fiscal
    year. The difference between
    the two curves equals the
    U.S. budget deficit (when expenditures exceed revenues)
    or surplus (when revenues
    exceed expenditures).

    2,200

    2,300
    2,100

    Expenditures, Revenues (billions of dollars)

    2,000
    1,900
    1,800
    1,700
    1,600
    1,500
    1,400
    1,300

    Expenditures

    1,200
    1,100
    1,000
    900

    Revenues

    800
    700
    600
    500
    400
    300
    200
    100
    0

    '40

    '45

    '50

    '55

    '60

    '65

    '70

    '75

    '80

    '85

    '95

    '00

    '05

    '90 '95

    '00

    '05

    '90

    Year
    Source: Data are drawn from Statistical Abstract of the United States, 2006.

    Figure 5

    45

    U.S. Government Expenditures as a Percentage of
    Gross Domestic Product

    42

    33

    Percentage of GDP

    The U.S. federal government
    spending as a percentage of
    the GDP reached a high of 44
    percent in 1943 and 1944.
    Discounting wartime spending and cutbacks after the
    war, you can see the upward
    trend in U.S. government
    spending, which constituted
    a larger and larger share of
    the GDP until the early
    1980s.

    39
    36
    30
    27
    24
    21
    18
    15
    12
    9
    6
    3
    0 '35

    '40

    '45

    '50

    '55

    '60

    '65

    '70

    '75

    '80

    '85

    Year

    288

    Part Three / The National and Global Economies

    Figure 6
    The U.S. Deficit
    As part (a) shows, since 1940, the U.S. government has
    rarely shown a surplus. For much of the 1950s and 1960s,
    the United States was close to a balanced budget. Part (b)
    shows the federal deficit as a percentage of GDP. The
    deficits during the 1950s and 1960s generally were small.
    (a) Federal Surplus (+) or Deficit (–)

    (b) Federal Deficit as a Percent of GDP
    (absolute value of deficit)

    200
    150
    100

    Deficit as Percent of GDP (percent)

    Budget Surplus or Deficit (billions of dollars)

    250

    The early 1980s were a time of rapid growth in the federal budget deficit, and this is reflected in the growth of
    the deficit as a percentage of GDP. From the late 1990s
    into the 2000s, there was a brief period of budget
    surpluses.

    50
    0
    –50
    –100
    –150
    –200
    –250
    –300
    –350
    –400

    '40 '45 '50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00 '05

    30
    28
    26
    24
    22
    20
    18
    16
    14
    12
    10
    8
    6
    4
    2
    0

    '40 '45 '50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00 '05

    Year

    ?

    Year

    the result of strong economic growth’s generating surprisingly large tax revenue
    gains combined with only moderate government spending increases. However,
    with the recession of 2001, the country soon returned to deficits.

    2.c. Deficits and the National Debt
    3. What are the effects of
    budget deficits?

    The large federal deficits of the 1980s and 1990s led many observers to question
    whether a deficit can harm the economy. Figure 6 shows how the fiscal deficit
    has changed over time. One major implication of a large deficit is the resulting
    increase in the national debt, the total stock of government bonds outstanding.
    Table 1 lists data on the debt of the United States. The total debt more than
    doubled between 1980 and 1986. Column 3 shows debt as a percentage of GDP.
    During World War II, the debt was greater than the GDP for five years. Despite
    the talk of “unprecedented” federal deficits in the 1980s and 1990s, clearly the
    ratio of the debt to GDP was by no means unprecedented.
    We have not yet answered the question of whether deficits are bad. To do so,
    we have to consider their potential effects.
    2.c.1. Deficits, Interest Rates, and Investment Because government
    deficits mean government borrowing and debt, many economists argue that deficits
    raise interest rates. Increased government borrowing raises interest rates, which in
    turn can depress investment. (Remember that as interest rates rise, the rate of return
    on investment drops, along with the incentive to invest.) What happens when

    Chapter 13 / Fiscal Policy

    289

    Table 1
    Debt of the U.S.
    Government (dollar
    amounts in billions)

    (1)

    (2)
    Total Debt

    (3)
    Debt/GDP
    (percent)

    Year

    (4)

    (5)
    Interest/Government
    Spending (percent)

    Net Interest

    1958

    $ 279.7

    63

    $ 5.6

    6.8

    1960

    290.5

    57

    6.9

    7.5

    1962

    302.9

    55

    6.9

    6.5

    1964

    316.1

    50

    8.2

    6.9

    1966

    328.5

    44

    9.4

    7.0

    1968

    368.7

    43

    11.1

    6.2

    1970

    380.9

    39

    14.4

    7.4

    1972

    435.9

    38

    15.5

    6.7

    1974

    483.9

    34

    21.4

    8.0

    1976

    629.0

    37

    26.7

    7.3

    1978

    776.6

    36

    35.4

    7.9

    1980

    909.1

    34

    52.5

    9.1

    1982

    1,137.3

    36

    85.0

    11.6

    1984

    1,564.7

    42

    111.1

    13.2

    1986

    2,120.6

    50

    136.0

    13.7

    1988

    2,601.3

    54

    151.8

    14.3

    1990

    3,206.6

    59

    184.2

    14.7

    1992

    4,002.1

    68

    199.4

    14.4

    1994

    4,643.7

    70

    203.0

    13.9

    1996

    5,181.9

    69

    241.1

    15.5

    1998

    5,478.7

    63

    241.2

    14.6

    2000

    5,629.0

    57

    223.0

    12.5

    2002

    6,198.4

    60

    171.0

    8.5

    2004

    7,354.7

    64

    160.2

    7.0

    2006

    8,451.4

    65

    226.6

    8.5

    government borrowing crowds out private investment? Lower investment means
    fewer capital goods in the future, so deficits lower the level of output in the economy both today and in the future. In this sense, deficits are potentially bad.
    2.c.2. Deficits and International Trade If government deficits raise real interest rates (the nominal interest rate minus the expected inflation rate), they also
    may have an effect on international trade. A higher real return on U.S. securities
    makes those securities more attractive to foreign investors. As the foreign demand
    for U.S. securities increases, so does the demand for U.S. dollars in exchange for
    Japanese yen, British pounds, and other foreign currencies. As the demand for
    dollars increases, the dollar appreciates in value on the foreign exchange market.
    This means that the dollar becomes more expensive to foreigners while foreign
    currency becomes cheaper to U.S. residents. This kind of change in the exchange
    rate encourages U.S. residents to buy more foreign goods and foreign residents to
    buy fewer U.S. goods. Ultimately, then, as deficits and government debt increase,
    U.S. net exports fall. Many economists believe that the growing fiscal deficits of
    the 1980s were responsible for the record decline in U.S. net exports during that
    period.

    290

    Part Three / The National and Global Economies

    The U.S. federal budget deficit rose from $73.8 billion in 1980 to $212.3 billion in 1985. During this time, the dollar appreciated in value from 1.95 German
    marks per dollar to 3.32 marks per dollar and from 203 Japanese yen per dollar to
    260 yen per dollar. (Note: German marks were replaced by euros in 2002.) These
    changes in the dollar exchange rate caused U.S. goods to rise in price to foreign
    buyers. For instance, a $1,000 IBM personal computer would sell for 1,950
    German marks at the exchange rate of 1.95 marks per dollar. But at the rate of
    3.32 marks per dollar, the $1,000 computer would sell for 3,320 marks. Furthermore, foreign currencies became cheaper to U.S. residents, making foreign goods
    cheaper in dollars. In 1980, one German mark sold for $.51. In 1985, one mark
    sold for $.30. At these prices, a Volkswagen wheel that sells for 100 marks would
    have changed in dollar price from $51 to $30 as the exchange rate changed. The
    combination of the dollar price of U.S. imports falling and the foreign currency
    price of U.S. exports rising caused U.S. net exports to fall dramatically at the
    same time that the fiscal deficit rose dramatically. Such foreign trade effects are
    another potentially bad effect of deficits.
    2.c.3. Interest Payments on the National Debt The national debt is the
    stock of government bonds outstanding. It is the product of past and current budget
    deficits. As the size of the debt increases, the interest that must be paid on the debt
    tends to rise. Column 4 of Table 1 lists the amount of interest paid on the debt; column 5 lists the interest as a percentage of government expenditures. The numbers
    in both columns have risen steadily over time and only recently experienced a brief
    fall before rising again.
    The steady increase in the interest cost of the national debt is an aspect of fiscal
    deficits that worries some people. However, to the extent that U.S. citizens hold
    government bonds, we owe the debt to ourselves. The tax liability of funding the
    interest payments is offset by the interest income bondholders earn. In this case
    there is no net change in national wealth when the national debt changes.
    Of course, we do not owe the national debt just to ourselves. Over time, the
    share of U.S. debt held by foreigners has grown. The United States is the world’s
    largest national financial market, and many U.S. securities, including government
    bonds, are held by foreign residents. In 1965, foreign holdings of the U.S. national
    debt amounted to about 5 percent of the outstanding debt. By 2006, this figure had
    risen to about 37 percent. Because the tax liability for paying the interest on the
    debt falls on U.S. taxpayers, the greater the payments made to foreigners, the lower
    the wealth of U.S. residents, other things being equal.
    Other things are not equal, however. To understand the real impact of foreign
    holdings on the economy, we have to evaluate what the economy would have been
    like if the debt had not been sold to foreign investors. If the foreign savings placed
    in U.S. bonds allowed the United States to increase investment and its productive
    capacity beyond what would have been possible in the absence of foreign lending,
    then the country could very well be better off for selling government bonds to foreigners. The presence of foreign funds may keep interest rates lower than they
    would otherwise be, preventing the substantial crowding out associated with an increase in the national debt.
    So while deficits are potentially bad due to the crowding out of investment,
    larger trade deficits with the rest of the world, and greater interest costs of the
    debt, we cannot generally say that all deficits are bad. It depends on what benefit
    the deficit provides. If the deficit spending allowed for greater productivity than
    would have occurred otherwise, the benefits may outweigh the costs.

    2.d. Automatic Stabilizers
    We have largely been talking about discretionary fiscal policy, the changes in
    government spending and taxing that policymakers make consciously. Automatic

    Chapter 13 / Fiscal Policy

    291

    progressive tax: a tax whose
    rate rises as income rises
    regressive tax: a tax whose
    rate falls as income rises
    proportional tax: a tax whose
    rate is constant as income rises

    R E C A P

    292

    stabilizers are the elements of fiscal policy that change automatically as income
    changes. Automatic stabilizers partially offset changes in income: as income falls,
    automatic stabilizers increase spending; as income rises, automatic stabilizers
    decrease spending. Any program that responds to fluctuations in the business cycle
    in a way that moderates the effect of those fluctuations is an automatic stabilizer.
    Examples are progressive income taxes and transfer payments.
    In our examples of tax changes, we have been using lump-sum taxes—taxes
    that are a flat dollar amount regardless of income. However, income taxes are determined as a percentage of income. In the United States, the federal income tax
    is a progressive tax: as income rises, so does the rate of taxation. A person with
    a very low income pays no income tax while a person with a high income can pay
    more than a third of that income in taxes. Countries use different rates of taxation
    on income. Taxes can be regressive (the tax rate falls as income rises) or proportional (the tax rate is constant as income rises). But most countries, including the
    United States, use a progressive tax, with the percentage of income paid as taxes
    rising with taxable income.
    Progressive income taxes act as an automatic stabilizer. As income falls, so does
    the average tax rate. Suppose a household earning $60,000 must pay 30 percent of
    its income ($18,000) in taxes, leaving 70 percent of its income ($42,000) for
    spending. If that household’s income drops to $40,000, and the tax rate falls to 25
    percent, the household has 75 percent of its