Economics PDF - Ivy Tech Curriculum

Economics Curriculum Ivy Tech Status In progress Term Fall Semester Chapter 1 - Introducing the Economic Way of Thinking Economics is sometimes referred to as the “science of choice.” Scarcity is...

Economics Curriculum Ivy Tech Status In progress Term Fall Semester Chapter 1 - Introducing the Economic Way of Thinking Economics is sometimes referred to as the “science of choice.” Scarcity is the condition in which human wants are forever greater than the available supply of time, goods, and resources. In some parts of the world, the problem of scarcity is often life- threatening. In more developed countries, the problem of scarcity is about people having all the goods and services they would like to have. Micro economics is the study of the economy in the small. Looking at individual markets. Macro economics has to do with the whole economy. We look at everything as a whole. Economics is the study of how society chooses to allocate its scarce resources to satisfy unlimited wants. Micro changes affect the macro economy, and macro changes produce micro changes. What products will be produced? The problem of scarcity restricts out ability to produce everything we want during a given period, so the choice to produce more of one good requires producing less of another good. How will they be produced? Economics 1  Because of scarcity, no society has enough resources to produce all the goods and services necessary to satisfy all human wants. Resources, also called factors of production or inputs, are divided into three categories: 1. Land Land is any natural resource provided by nature that is used to produce a good or service. Land includes anything natural above or below the ground, such as forests, gold, diamonds, oil, coal, wind, and the ocean 2. Labor Labor is the mental and physical capacity of workers to produce goods and services. Labor is measured both by the number of people available for work and by the skills or quality of workers. 3. Capital Capital is a human-made good used to produce other goods and services. It includes physical plants, machinery, equipment, roads, and bridges. For whom will they be produced? In some economic systems, the For Whom question is largely decided by the government, while in others, it is decided by the owners of the factors of production The Methodology of Economics Step 1: Identify the problem Step 2: Develop a model A model is a simplified description of reality used to understand and predict the relationship between variables. To be useful, a model requires simplified assumptions. Step 3: Gather data and test whether the theory can be supported by the data Step 4, Formulate a conclusion The Ceteris Paribus Assumption Ceteris paribus is a Latin phrase that means while certain variables change, “all other things remain unchanged.” It allows us to isolate or focus attention on selected variables. The ceteris paribus assumption, that all other things remain unchanged, is satisfied if we wish to correctly conclude there is a relationship between two variables. Correlation versus Causation A model is valid only when a cause-and-effect relationship is stable or dependable over time, rather than being an association that occurs by chance and eventually disappears. Correlation is association while causation is a cause. Economics 2  Efficiency versus Equity The term efficiency is used to describe a situation where society is doing the best it can with its existing resources and technology. Equity focuses on fairness in the way production is distributed among members of society. Many economic policies encounter the efficiency versus equity trade-off. Positive versus Normative Economics Positive economics objectively deals with facts that can be tested. It addresses what is true or false regarding how the economy works. Normative economics subjectively deals with what ought to be based on value judgments that cannot be proven. The “art” of economics is applying the knowledge gained from positive economics to formulate policies to best achieve the goals of “what ought to be” in normative economics. Chapter 2 - Production Possibilities, Opportunity Cost, and Economic Growth Opportunity Cost Because of scarcity, people must make choices, and each choice incurs a cost (sacrifice). The money you spend for one thing, can’t be spent on another. Opportunity cost is the next best alternative that was sacrificed when making a choice. Marginal Analysis Marginal analysis examines the effects of incremental additions to or subtractions from a current situation. The rational decision make decided on an option only if the marginal benefit exceeds the marginal cost. The Production Possibilities Model Society’s capacity to produce combinations of goods is constrained by its limited resources. This can be represented in a model called the production possibilities curve (PPC). There are three assumptions when considering the production possibilities curve model: Fixed Resources The quantities and qualities of all resources remain unchanged during the time period. If an economy shifts workers from producing consumer goods to producing capital goods, the amount of workers is the same but there is less production of consumer goods. Fully Employed Resources All factors of production are fully employed and are producing the greatest output possible without waste or mismanagement. Fixed Technology Economics 3  Holding the level of existing technology fixed creates limits on the amounts and types of goods any economy can produce. Productive efficiency occurs when society produces the most it can with its existing resources and technology. All points on the production possibilities curve are productively efficient points. Scarcity limits an economy to points on or below its production possibilities curve. Allocative efficiency occurs when society allocates, or channels, its limited resources into the production of those products that are most desired by society. Only one point on the PPC will be allocatively efficient. Opportunity Cost and the Production Possibilities Curve The law of increasing opportunity costs states that the opportunity cost increases as production of one output expands. Because resources are not equally suited to the production of all goods, it’s common to experience increasing opportunity costs and a bowed-out production possibilities curve. Sources of Economic Growth The economy’s production capacity is not permanently fixed. If either the quantity or the quality of resources increase or technology advances, the economy will grow and the PPC will shift outward. Economic growth is the ability of an economy to produce greater levels of output. An increase in resources (land, labor, capital) will shift the PPC outward. A reduction in resources will cause the PPC to shift inward. Another way the economy grows is with productivity increasing of existing resources. Improved technology will result in higher productivity. Innovation involves developing new productive processes. Investment is the accumulation of capital used to produce goods and services. A nation can accelerate economic growth by devoting more resources to the production of capital goods. While this increases economic growth and provides for higher standards of living over time, it can be unpopular because it entails an opportunity cost—it requires current sacrifice of consumer products. Chapter 3 - Market Demand and Supply Demand The law of demand states that there is an inverse relationship between the price of a good and the quantity buyers are willing to purchase. A demand curve shows the different quantities of a product consumers are willing to purchase at various prices. To find the market demand, add the demand of all individuals. A market demand curve is derived by horizontally summing the individual demand curves of all consumers in the market. Changes in nonprice determinants shift the demand curve. Increases in demand shift the demand curve to the right while decreases in demand shift the demand curve to the left. Economics 4  Nonprice determinants or demand shifts change the demand of a product without changing the price. There are 5 major nonprice determinants that can shift the demand curve: 1. Number of Buyers - Direct 2. Tastes and Preferences - Direct 3. Income - Direct/Inverse 4. Expectations of Buyers - Direct 5. Prices of Related Goods - Direct/Inverse There are two types of goods: normal goods and inferior goods. A normal good is any good for which there is a direct relationship between changes in income and its demand curve. Examples are cars, steaks, vintage wine, cleaning services, and T-shifts. An inferior good is any good for which there is an inverse relationship between changes in income and its demand curve. Examples are generic brand products, discount clothes, and used cars. If income is higher, people will buy more normal goods and less inferior goods. A substitute good competes with another good for consumer purchases. A complementary good is jointly consumed with another good. If the price for cream goes up, the demand for it an coffee go down. Changing the price of any other product is considered changing a nonprice determinant. Changing the price of a good causes a change in the quantity demanded, shown as movement along the demand curve. Changing a nonprice determinant causes a change in demand, shown as a shift of the entire demand curve. Supply The law of supply states there is a direct relationship between the price of a good and the quantity sellers are willing to offer for sale. A supply curve shows the different quantities of a product sellers are willing to produce and offer for sale at various prices. To find market supply, sum all the quantities supplied by individual firms at various prices that might prevail in the market. A change in quantity supplied is a movement from one point to another point along a stationary supply curve An increase in supply will shift the supply curve to the right while decreases in supply will shift the supply curve to the left. A change in supply is an increase or a decrease in the quantity supplied at each possible price. There are five major nonprice determinants that can shift the supply curve: 1. The number of sellers - Direct 2. Technology - Direct 3. Resource prices - Inverse 4. Expectations of sellers - Inverse Economics 5  5. Price of other goods the firm can product - Inverse Changing the price of a good changes the quantity supplied an dis shown as movement along the supply curve. Changes in any nonprice determinant change supply and is shown as a shift of the entire supply curve. Market Equilibrium A market is any arrangement in which buyers and sellers interact to determine the price and quantity of goods and services exchanged. A surplus is a market condition existing at any price where the quantity supplied is greater than the quantity demanded. If there is a surplus, competition forces sellers to lower their selling price. A shortage is a market condition existing at any price where the quantity supplied is less than the quantity demanded. A shortage will cause the price of a product to increase. Equilibrium occurs at an price and quantity where the quantity demanded and the quantity supplied are equal. It is also called market clearing. Graphically, the intersection of the supply curve and the demand curve is the market equilibrium price-quantity point. This is the price where there is neither a shortage nor a surplus and quantity demanded exactly equals quantity supplied. The price system is a mechanism that uses the forces of supply and demand to create equilibrium through rising and falling prices. Prices are established in markets to distribute scarce and limited goods to those who are willing and able to pay the prevailing market price. Changes in Market Equilibrium Change Effect on Equilibrium Price Effect on Equilibrium Quantity Demand increases Increases Increases Demand decreases Decreases Decreases Supply increases Decreases Increases Supply decreases Increases Decreases Chapter 4 - Markets in Action Market Efficiency The demand curve, which shows the consumers’ willingness to pay for a product, is the marginal benefit curve. The supply curve, which shows the minimum price necessary for producers to cover the opportunity cost of production and be willing to offer a product for sale, is the marginal cost curve. The competitive market equilibrium is efficient because at that level of production, the marginal benefit of consumption is just equal to the marginal cost of production. Economics 6  In market efficiency marginal benefit = marginal cost Sources of Market Failure Market failure occurs when market equilibrium results in too few or too many resources being used in the production of a good or service. There are three cases or market failure Lack of competition Without competition, companies can restrict the supply and increase the price of a product. If firms are able to reduce competition by colluding to restrict supply, then will result an inefficient equilibrium with an artificially high price and too few resources devoted to the production of the good. Externalities An externality is a cost or benefit impost on people other than the consumers and producers of a good or service. They are also called spillovers, spillover effects, or neighborhood effects. People other than consumers and producers who are affected by these side effects of market exchanges are called third parties. When the supply curve fails to include external costs, the equilibrium price is artificially low, and the equilibrium quantity is artificially high. External costs cause the market to over- allocate resources. When the demand curve fails to include external benefits, the equilibrium price is artificially low, and the equilibrium quantity is artificially low. External benefits cause the market to under-allocate resources. Public Goods A public good is a good or service that, once produced, has two properties: 1. Users collectively consume the benefits 2. There is no way to bar people who do not pay from consuming the good or service If public goods are available only in the marketplace, people wait for someone else to pay, and the result is an underproduction or zero production of public goods. Policies to Correct Market Failure The government has three tools to influence the market Regulation Regulation is often used to override market inefficiencies. Price Controls Sometimes the government will intervene and maintain a price higher than the market equilibrium price. Economics 7  A price ceiling is a legally established maximum price a seller can charge. If a price ceiling is set below the equilibrium price, there will be a shortage. Demand will go up but supply will remain the same. A price floor is a legally established minimum price a seller can be paid. The minimum wage is an example of this. Minimum wage causes unemployment because there is more supply than demand of workers. Taxes and Subsidies Governments can take money from people for selling things or give money for buying things. Chapter 5 - Elasticity Price Elasticity of Demand Price elasticity of demand explains how strongly consumers react to a change in price. Price elasticity of demand is the ratio of the percentage change in the quantity demanded of a product to the percentage change in its price. Ed = (P ercentage change in quantity demanded)/P ercentage change in price ​ The demand curve is elastic when Ed > 1 and the total revenue rises when prices fall. The demand curve is inelastic when Ed < 1 and the total revenue falls when prices fall. The demand curve is unitary elastic when Ed = 1 and the total revenue doesn’t change when prices fall. Perfectly elastic demand (Ed = ∞) is a condition in which a small percentage change in price brings about an infinite percentage change in the quantity demanded. Perfectly inelastic demand (Ed = 0) is a condition in which the quantity demanded does not change as the price changes. Total revenue is the total number of dollars a firm earns from the sale of a good or service. The price elasticities of demand can change because of the following factors: Availability of substitutes Demand becomes more elastic for a good or service when the number of close substitutes increases. Share of budget spent on the product Adjustment to a price change over time Economics 8  Price Elasticity of Demand along a Demand Curve When demand is elastic, a decrease in price results in a relatively larger increase in the quantity sold, and total revenue increases. When demand is inelastic, a decrease in price results in a relatively small increase in the quantity sold, and total revenue falls. Price Elasticity of Demand Elasticity Coefficient Price Quantity Total Revenue Elastic Ed > 1 Decrease Larger Increase Increase Elastic Ed > 1 Increase Larger Decrease Decrease Unitary Elastic Ed = 1 Decrease Same Increase No Change Unitary Elastic Ed = 1 Increase Same Decrease No Change Inelastic Ed < 1 Decrease Smaller Increase Decrease Inelastic Ed < 1 Increase Smaller Decrease Increase Other Elasticity Measures Income elasticity of demand is the ratio of the percentage change in the quantity demanded of a good or service given the percentage change in income Formula for income elasticity of demand For a normal good or service, Ei > 0. For an inferior good, Ei < 0. Cross-elasticity of demand is the ratio of the percentage change in the quantity demanded of a good or service to a given percentage change in the price of another good or service. Cross-elasticity of demand formula Price elasticity of supply is the ratio of the percentage change in the quantity supplied of a product to the percentage change in its price. Economics 9  Elasticity Coefficient Type Definition Terminology Possibilities Percentage change in quantity Income elasticity Ei > 0 Normal good demanded / Percentage change in of demand Ei < 0 Inferior good income Percentage change in quantity Cross-elasticity of Ec < 0 Complements demanded of one good / Percentage demand Ec > 0 Substitutes change in price of another good Es > 1 Elastic Es = 1 Unitary elastic Price elasticity of Percentage change in quantity supplied Es < 1 Inelastic supply / Percentage change in price Es = ∞ Perfectly elastic Es = 0 Perfectly inelastic Price Elasticity and Taxation Tax incidence is the share of a tax ultimately paid by consumers and sellers. It is determined by the price elasticity of demand and supply. Chapter 6 - Production Costs Costs and Profit Explicit costs are payments to nonowners of a firm for their resources. Implicit costs are the opportunity costs of using resources owned by a firm. Profit = total revenue - total cost Accounting profit = total revenue - total explicit cost Economic profit = total revenue - total opportunity costs or: Economic profit = total revenue - (explicit costs + implicit costs) Normal profit is the minimum profit necessary to keep a firm in operation. Since business decision making is based on economic profit, rather than accounting profit, the word profit in this text always means economic profit. Short-Run Production A fixed input is any resource for which the quantity cannot change during the period of time under consideration. The short run is a period of time so short that there is at least one fixed input. The long run is a period of time so long that all inputs are variable. A production function is the relationship between the maximum amounts of output a firm can produce and various quantities of input. Marginal product is the change in total output produced by adding one unit of a variable input, with all other inputs used being held constant. The law of diminishing returns states that beyond Economics 10  some point the marginal product decreases as additional units of a variable factor are added to a fixed factor. Marginal product (MP) measures the change to total output that results from hiring an additional worker. Marginal product may increase initially as workers specialize, but diminishing returns will always eventually occur in the short run as workers must share limited fixed inputs. Short-Run Cost of Production Total fixed cost (TFC) consists of costs associated with paying for fixed inputs that do not vary as output varies and that must be paid even if output is zero. Examples are rent, loans, taxes, and insurance. Total variable cost (TVC) consists of costs associated with paying for variable inputs that are zero when output is zero and vary as output varies. Examples are wages, electricity, fuel, and raw materials. The total cost (TC) is the sum of the TFC and TVC Average fixed cost (AFC) is the total fixed cost divided by the quantity of output produced. AFC = TFC/Q Average variable cost (AVC) is the total variable cost divided by the quantity of output produced. AVC = TVC/Q Average total cost (ATC) is total cost divided by the quantity of output produced. ATC = TC/Q or ATC = AFC + AVC Marginal cost (MC) is the change in total cost when one additional unit of output is produced. MC = change in TC/change in Q Marginal Cost Relationships Economics 11  The marginal-average rule states that when marginal cost is below average cost, average cost falls. When marginal cost is above average cost, average cost rises. When marginal cost equals average cost, average cost is at its minimum point. As marginal product increases and workers are more productive, the marginal cost of production falls. As diminishing returns occur and marginal product decreases, the marginal cost of production rises. Long-Run Production Costs A firm operates in the short run when there is insufficient time to alter some fixed input. The firm plans in the long run when all inputs are variable. The plant size selected by a firm in the long run depends on the expected level of production. The long-run average cost curve (LRAC) traces the lowest cost per unit at which a firm can produce any level of output after the firm can build any desired plant size. Economies of scale exist when the LRAC declines as the firm increases output. Constant returns to scale exist when the LRAC doesn’t change as the firm increases output. Diseconomies of scale exist when the LRAC rises as the firm increases output. Chapter 7 - Perfect Competition Perfect Competition A market structure describes the key traits of a market, including number of firms, similarity of the products, and ease of entry into and exit from the market. Perfect competition is characterized by: A large number of small firms A homogeneous product Very easy entry into or exit from the market A homogenous product means that a good from each firm is identical. A barrier to entry is any obstacle that makes it difficult for a new firm to enter a market. A price taker is a seller that has no control over the price of the product it sells. It is determined by supply and demand conditions. An individuals firm’s demand curve is perfectly elastic in these conditions. Short-Run Profit Maximization for a Perfectly Competitive Firm Marginal revenue is the extra revenue or the change in total revenue from the sale of one additional unit of output. MR = Change in total revenue/one-unit change in output In perfect competition, the firm’s marginal revenue equals the price, which the firm views as a horizontal demand curve. The firm maximizes profit by producing the output where marginal Economics 12  revenue equals marginal cost. Short-Run Supply Under Perfect Competition Profit can be calculated as (P-ATC)*Q, so when price exceeds ATC the firm earns a positive economic profit, when they are equal a normal profit is earned, and when price falls below ATC the firm earns a loss. If the price is below the minimum point on the AVC curve, each unit produced would not even cover the variable cost per unit; therefore, operating losses would exceed fixed costs and the firm should shut down. Long-Run Supply Under Perfect Competition If there are profits, new firms enter the industry and shirt the short-run supply curve to the right. This causes prices to fall until profits reach zero in the long run. If there are economic losses in an industry, existing firms leave, causing the short-run supply curve to shift left and prices rise. The perfectly competitive industry’s long-run supply curve shows the quantities supplied by the industry at different equilibrium prices after firms complete their entry and exit. A constant-cost industry is an industry in which the expansion of industry output by the entry of new firms has no effect on the firm’s SRATC cost curve. In perfect competition, new firms are free to enter the industry. The long-run supply curve in a perfectly competitive constant-cost industry is perfectly elastic and drawn as a horizontal line. A decreasing-cost industry is an industry in which the expansion of industry output by the entry of new firms decreases each individual firm’s cost curve. The long-run supply curve in a perfectly competitive decreasing-cost industry is downward sloping. An increasing-cost industry is an industry in which the expansion of industry output by the entry of new firms increases the individual firm’s cost curve. The long-run supply curve in a perfectly competitive increasing-cost industry is upward sloping. Chapter 8 - Monopoly Monopoly is a market structure characterized by: A single seller A unique product with no close substitutes Impossible entry into the market Local monopolies are more common real-world approximations of the model than national or world market monopolies. There can be an impossible entry into the market because of: Ownership of a Vital Resource Legal Barriers Economics 13  Economies of Scale A natural monopoly is an industry in which the long-run average cost of production declines over the full range of output in the market. Natural monopoly occurs when a single firm in an industry can produce enough output to satisfy market demand and produce this output at a lower per-unit cost than would be possible if the market were served by more than one firm. Price and Output Decisions for a Monopolist A price maker is a firm that faces a downward-sloping demand curve. This means a monopolist has the ability to select the product’s price. Because a monopolist is the only seller of a product, its demand curve is the downward sloping market demand curve. The monopolist’s marginal revenue curve is also downward sloping and always lies below the demand curve. The marginal revenue curve for a straight-line demand curve intersects the quantity axis halfway between the origin and the quantity axis intercept of the demand curve. The monopolist maximizes profit by producing the level of output where MR = MC and charging the corresponding price from the demand curve. This always occurs at a price on the elastic segment of its demand curve. Having a monopoly doesn’t guarantee profits. A monopolist has no protection against changes in demand or cost conditions. Strong barriers to entry protect a monopolist from competitors, allowing them to earn economic profits in the long run. Price discrimination Price discrimination occurs when a seller charges different prices for the same product that are not justified by cost differences. Arbitrage is the practice of earning a profit by buying a good at a low price and reselling the good at a higher price. To be able to engage in price discrimination the seller must: Be a price maker and have a downward-sloping demand curve Be able to segment the market by distinguishing between consumers willing to pay different prices It must be too costly for customers to engage in arbitrage. By separating the market into groups with different price elasticities of demand for their product and charging a higher price to customers with a more inelastic demand, a firm that price discriminates earns a higher profit than they would if they charged the same price to all buyers. Comparing Monopoly and Perfect Competition Monopoly markets are characterized by inefficiency because resources are under allocated to the production of that product. Perfectly competitive markets are characterized by efficiency as the marginal benefit of the last unit exchanged equals the marginal cost of producing it. Economics 14  The monopolist charges a higher price and produces a lower output than would result under a perfectly competitive market structure. Economist’s case against monopoly: A monopolist charges a higher price than would be charged under perfect competition Because a monopolist restricts output in order to maximize profit, too few resources are used to produce the product. Long-run economic profit for a monopolist exceeds the zero economic profit earned in the long run by a perfectly competitive firm Monopoly alters the distribution of income in favor of the monopolist Chapter 9 - Monopolistic Competition and Oligopoly The Monopolistic Competition Market Structure A monopolistic competition market structure is characterized by: Many small sellers A differentiated product Easy market entry and exit It is the most common market structure in the United States. Product differentiation is the process of creating real or apparent differences between goods and services. With nonprice competition, a firm competes by using advertising, packaging, product design, better quality, better service, more convenient hours of operation, and a better location, rather than by using lower prices. Price and Output Decisions for a Monopolistically Competitive Firm Like a monopolist, a monopolistically competitive firm faces a downward sloping demand curve and maximizes profit by producing the level of output where MR = MC and charging the corresponding price read off the demand curve at that level of output. A monopolistically competitive firm will not earn an economic profit in the long run but will earn only a normal profit in the long run. Any short run profits will be competed away as new firms enter the industry. Monopolistic Competition and Efficiency A monopolistically competitive firm fails the efficiency test. The criticism of monopolistic competition, then, is that there are too many firms producing too little output at inflated prices, wasting society’s resources in the process. The Oligopoly Market Structure Economics 15  An oligopoly market structure is characterized by: A few large sellers Either a homogeneous or differentiated product Difficult market entry Many manufacturing industries are described as oligopolistic industries. Mutual interdependence is a condition in which an action by one firm may cause a reaction from other firms. Models of Oligopoly There are four well-known oligopoly models: The kinked demand curve The kinked demand curve is a demand curve facing an oligopolist that assumes rivals will match a price decrease, but will ignore a price increase. Oligopolistic firms are price makers. The price established at the king changes very infrequently. Price leadership Price leadership is a pricing strategy in which a dominant firm sets the price for an industry and the other firms follow. The cartel This model assumes that firms do not collude to avoid price competition. A cartel is a group of firms that formally agree to reduce competition by coordinating the price and output of a product. Its goal is to reap monopoly profits by replacing competition with cooperation. Cartels are illegal in the United States. Game theory Game theory is a model of the strategic moves and countermoves of rivals. The payoff matrix demonstrates why a competitive oligopoly tends to result in both rivals using a low-price strategy that does not maximize mutual profits. Example with Delta and American Airlines Economics 16  The price in oligopoly is higher than under perfect competition. An oligopoly is likely to spend money on advertising, product differentiation and other forms of non price competition. A oligopolist can earn an economic profit in the long run because of the difficult entry. Reviews of the Different Market Structures Market Number of Type of Entry Condition Control of Price Examples Structure Sellers Product Perfect Large Homogeneous Very easy Price taker Agriculture Competition Monopoly One Unique Impossible Price maker Public utilities Monopolistic Many Differentiated Easy Price maker Retail trade Competition Homogeneous Auto, steel, oil, Oligopoly Few or Difficult Price maker pharmaceuticals differentiated Chapter 10 - Labor Markets The Labor Market Under Perfect Competition The marginal revenue product is the increase in a firm’s total revenue resulting from hiring an additional unit of labor. MRP = MP*P. The demand curve for labor is a curve showing the different quantities of labor employers are willing to hire at various wage rates. A firm hires additional workers up to the point where the MRP equals the wage rate. The derived demand for labor and other factors of production depends on the consumer demand for the final goods and services the factors produce. The supply curve of labor shows the different quantities of labor workers are willing to offer employers at various wage rates. There is a direct relationship between the wage rate and the quantity of labor supplied. Human capital is the accumulation of education, training, and experience, as well as the condition of a person’s health that enables a worker to enter an occupation and be productive. Each individual firm is a wage taker so the wage supply curve is horizontal. Changes is Labor Demand Changes in Labor Supply Unions Unions Price of substitute inputs Demographic trends Technology Expectations of future income Demand for final products Changes in immigration laws Marginal product of labor Education and training Economics 17  Labor Unions: Employee Power To raise wages unions: Increasing the demand for labor Feather bedding pushes firms to hire more workers than they otherwise would or to impose work rules that reduce output per worker. To increase wages, unions could undertake actions that increase the demand curve for labor. Decreasing the supply of labor To increase wages, unions could undertake actions that decrease the supply of labor. Exerting power to force employers to pay a wage rate above the equilibrium wage rate Collective bargaining is the process of negotiating labor contracts between the union and management concerning wages and working conditions. After a union has been certified as the representative of a majority of the workers, employers must deal with the union. If employers deny union demands, the union can strike and reduce profits until firms agree to a higher wage rate. This will create some unemployment in that industry, Employer Power: Monopsony Monopsony is a labor market in which a single firm hires labor. Marginal factor cost is the additional total cost resulting from a one-unit increase in the quantity of a factor. Because the monopsonist can hire additional workers only by raising the wage rate for all workers, the marginal factor cost exceeds the wage rate. The monopsonist in the labor market hires the quantity of labor at which the marginal revenue product of labor equals its marginal factor cost. A monopsonist hires fewer workers and pays a lower wage than a firm in a competitive labor market by hiring the number of workers where MRP = MFC. Chapter 12 - Gross Domestic Product Gross Domestic Product Gross domestic product (GDP) is the market value of all final goods and services produced in a nation during a period of time. GDP is measured in dollars instead of quantity produced. GDP counts only for new domestic production. GDP excludes secondhand transactions and nonproductive financial transactions. It also doesn’t count private or public financial transactions such as gifts, stocks and bonds, and transfer payments. A transfer payment is a government payment to individuals not in exchange for goods or service currently produced. Social security is a transfer payment. GDP only counts for final goods which are finished goods and services produced for the ultimate user. Intermediate goods are goods and services used as inputs for the production of final goods and are not measure in GDP. Economics 18  Measuring GDP The circular flow model shows the exchange of money, products, and resources between households and businesses. The upper half of the model represents product markets where households exchange money for goods and services produced by firms. The bottom half represents factor markets where firms demand the natural resources needed to produce goods and services sold in product markets. This model assumes no savings on both parties. If there is more spending, the GDP is higher. If spending falls, the GDP is lower. Changes in GDP impact employment, incomes, further spending, and standards of living. A flow is a rate of change in a quantity during a given time period. The arrows in the model are flows. Flows are measured in units per time period. A stock is a quantity measured at one point in time. Stocks are measured in units such as tons, dollars, or gallons. The Expenditure Approach The expenditure approach measures GDP by adding all the spending for final goods during a period of time. Personal consumption expenditures(C) is household spending for durable goods, nondurable goods, and services. Durable goods are items that last longer than three years. Nondurable goods are used up or consumed in less than three years. Services are any transaction not in the form of a tangible object. Gross private domestic investment(I) all non government, non foreign, spending by business for investment in capital assets that are expected to earn profits in the future. It is measure by the sum of two components: 1. Fixed investment expenditures for newly produced capital goods, such as commercial and residential structures, machinery, equipment, tools, and computers 2. Change in business inventories, which is the net change in spending for unsold finished goods It doesn’t include personal investments in stocks, bonds, and other financial assets. A new home is considered investment because it provides services in the future that the owner can Economics 19  rent for financial return. Government spending(G) is the value of goods and services government at all levels purchased measured by their costs. This excluded transfer payments. Exports(X) are spending by foreigners for U.S. domestically produced goods. Imports(M) are the dollar amount of U.S. purchases for goods produced abroad. If (x-m) is negative, the US is spending more dollars to purchase foreign products than it is receiving from abroad for goods sold to foreigners. Since 1983, the US has been a net importer. According to the expenditure approach: GDP = C + I + G + (X − M) The Income Approach The income approach measures GDP by adding all the incomes earned by households in exchange for the factors of production during a period of time. GDP = compensation of employees + rents + profits + net interest + indirect taxes + depreciation. Rents consist of the payments property owners receive for permitting others to use their assets. The three sources of corporate profits are dividends, undistributed corporate profits, and corporate income taxes. Corporate profits using the income approach are before taxes. Net interest is the difference between interest income and interest payments. Indirect business taxes are levied as a percentage of the prices of goods sold and therefore become part of the revenue received by firms. These taxes include sales tax, federal excise taxes, license fees, business property taxes, and customs duties. Firms collect indirect taxes and send the funds to the government. Consumption of fixed capital is an estimate of the depreciation of capital. GDP Shortcomings GDP excludes certain unpaid activities because it hard to accurately assign a dollar value to services people provide for themselves or others without compensation. GDP is blind to whether a small fraction of the population consumes most of a country’s GDP. It also doesn’t represent the quality of the goods being produced. Illegal transactions aren’t counted in GDP. This is called the underground economy. GDP doesn’t account for negative externalities or quality of life. If production results in pollution and environmental damage, GDP overstates the nation’s well-being. There are many shortcomings associated with GDP. As a result, it is important to remember that GDP was never intended to be a measure of the quality of life. Other National Income Accounts National income is the gross domestic product minus depreciation of the capital worn out in producing output. Personal income is the total income received by households that is available for consumption, saving, and payment of personal taxes. NI excludes transfer payments and Economics 20  includes corporate profits. Disposable person income is the amount of income that households actually have to spend or save after payment of personal taxes. Changing Nominal GDP to Real GDP Nominal GDP is the value of all final goods based on the prices existing during the time period of production. It can grow by output rising, prices rising. or both rising. Real GDP is the value of all final goods produced during a given time period based on the prices existing in a selected base year. The U.S. currently uses 2012 as the base year. The GDP chain price index is a measure that compares changes in the prices of all final goods produced during a given time period relative to the prices of those goods in a base year. Real GDP = (nominal GDP / GDP chain price index) * 100 Chapter 13 - Business Cycles and Unemployment The Business-Cycle Roller Coaster The business cycle consists of alternating periods of economic expansion and contraction. Each cycle is divided into four phases: Peak At a peak, real GDP reaches its maximum after rising during a recovery. Recession A recession is a downturn in the cycle during which real GDP declines. Recessions usually consist of at least two consecutive quarters in which there is a decline in real GDP. During a recession, the economy is functioning inside the PPC. Trough A trough is where the level of real GDP bottoms out after falling during a recession. Recovery (Expansion) Recovery is the upturn of the cycle where real GDP rises. Economic growth is an expansion in national output measured by the annual percentage increase in a nation’s real GDP. There are three types of economic indicator variables. Leading indicators are key variables that change before real GDP changes. Coincident indicators are variables that change at the same time that real GDP changes. Lagging indicators change after real GDP changes. Leading Indicators Coincident Indicators Lagging Indicators Average workweek Nonagricultural payrolls Unemployment rate Personal income minus transfer Unemployment claims Duration of unemployment payments Economics 21  Leading Indicators Coincident Indicators Lagging Indicators New consumer goods orders Industrial production Labor cost per unit of output Consumer price index for Delayed deliveries Manufacturing and trade sales services New orders for plant and Consumer-credit-to-personal- equipment income ratio New building permits Commercial and industrial loans Stock prices Prime rate Money Supply Interest rates Consumer expectations Expansion is caused by more spending and a recession is caused by declines in total spending. Unemployment The unemployment rate comes from the Bureau of Labor Statistics which conducts a survey of 60k households. Anyone who is 16 or older and works at least one hour for pay or 15 hours unpaid is considered employed. The unemployment rate is the percentage of people in the civilian labor force who are without jobs and are actively seeking jobs. The civilian labor force is the number of people 16 years old and older who are employed or unemployed, excluding members of the armed forces, homemakers, discouraged workers, and others. A discouraged worker is a person who wants to work, but has given up searching for work because they believe there will be no job offers. Types of Unemployment There are three types of unemployment: Frictional Frictional unemployment is temporary unemployment caused by the time require for workers to move from one job to another. It is a short-term situation. Structural Structural unemployment is unemployment caused by a mismatch of the skills of workers who are out of work and the skills required for existing job opportunities. It is a long term or permanent situation. There are four causes to this type of unemployment: Lack of education Changes in consumer demand Technological advances Globalization Economics 22  Outsourcing is the practice of a company having its work down by another company in another country. Offshoring occurs when a U.S. company hires employees from another country to perform jobs once done by the company’s American employees. Cyclical Cyclical unemployment is unemployment caused by the lack of jobs during a recession. There are not enough jobs for the workers. The Goal of Full Employment Full employment is the situation in which an economy operates at an unemployment equal to the sum of the frictional and structural unemployment rates. It doesn’t mean zero percent unemployment but cyclical unemployment is zero. It is approximately 95 %. The GDP gap is the difference between actual real GDP and full-employment real GDP. It is positive during a boom and negative during a recession. A negative GDP gap measures the economic cost of unemployment, which is the loss of potential goods and services that can’t be realized. Nonmonetary and Demographic Consequences of Unemployment The burden of unemployment is not evenly felt within our society. Chapter 14 - Inflation Meaning and Measurement of Inflation Inflation is an increase in the general price level of goods in the services in the economy, Deflation is a decrease in the general price level of goods and services in the economy. It doesn’t mean that all prices of all products change. The consumer price index (CPI) measures changes in the average prices of consumer goods and services. It doesn’t consider items purchased by businesses and government. It is called a fixed-weight price index because the composition of the market remains unchanged. A base year is a year chosen as a reference point for comparison with some earlier or later year. Currently, the CPI uses 1982-1984 spending patterns as its base year. The inflation rate is measured by the percent change in the CPI from one year to the next. Disinflation is a reduction in the rate of inflation. It doesn’t mean prices are falling but the rate of increases in prices is falling. Criticisms to CPI: It is based on a typical market basket of products that doesn’t match the actual market basket purchased by many consumers It doesn’t account for changes in quality Economics 23  It ignores the law of demand since it in a base year Consequences of Inflation Nominal income is the actual number of dollars received over a period of time. Real Income is the actual number of dollars received adjusted for changes in CPI. Real income = nominal income/CPI People whose nominal incomes rise faster than the rate of inflation gain purchasing power, while people whose nominal incomes do not keep pace with inflation lose purchasing power. Income is a flow on money earned by selling factors of production. Wealth is the value of the stock of assets owned at some point in time. Inflation tends to benefit holders of wealth because the value of the assets rise as prices rise. The nominal interest rate is the actual market rate of interest earned over a period of time. The real interest rate is the nominal interest rate minus the inflation rate. Adjustable-rate mortgage (ARMs) are home loans that adjust the nominal interest rate to changes in an index. When the real rate of interest is negative, lenders and savers lose because interest earned does not keep up with the inflation rate. Hyperinflation is an extremely rapid rise in the general price level. Inflation psychosis is when individuals and businesses buy quickly today to avoid paying more tomorrow. A wage-price spiral occurs in a series of steps when increases in nominal wage rates are passed on in higher prices which result in even higher nominal wage rates and prices Demand-Pull and Cost-Push Inflation Demand-pull inflation is a rise in the general price level resulting from an excess of total spending. It occurs at or close to full employment. Cost-push inflation is a rise in the general price level resulting from an increase in the cost of production. Chapter 15 - Aggregate Demand and Supply The Aggregate Demand Curve The aggregate demand curve (AD) shows the level of real GDP purchased by households, businesses, government, and foreigners at different possible price levels. Price is measured by CPI. It is different than a specific market demand curve. The AD is downward sloping. Reasons for the Aggregate Demand Curve’s Shape Real balances effect is the impact on total spending caused by the inverse relationship between the price level and the real value of financial assets with fixed nominal value. Consumers spend more on goods and services when prices fall because the purchasing power of their money increases. Economics 24  The interest-rate effect is the impact on total spending caused by the direct relationship between the price level and the interest rate. Higher interest rate discourage borrowing and spending and the quantity of the goods people wish to purchase falls. The net exports effect is the impact on total spending caused by the inverse relationship between the price level and the net exports of an economy. Effect Causation Chain Price level decreases → Purchasing power rises → Wealth rises → Real balances effect Consumers buy more goods → The quantity of real GDP demanded increases Price level decreases → Purchasing power rises → Demand for fixed supply Interest- rate effect of credit falls → Interest rates fall → Businesses and households borrow and buy more goods → The quantity of real GDP demanded increases Price level decreases → U.S. goods become less expensive than foreign Net exports effect goods → Americans and foreigners buy more US. goods → Exports rise and imports fall → The quantity of real GDP demanded increases Non-Price-Level Determinants of Aggregate Demand Changes in real GDP demanded are caused by changes in the price level. Changes in aggregate demand are caused by changes in one or more nonprice-level determinants. Anything that increases aggregate expenditures [C, I, G, (x-3)] shifts the AD curve rightward. On the other hand, anything that decreases total spending will shift the AD curve leftward. A rightward shift of the AD reflects an increase in total spending. The Aggregate Supply Curve The Aggregate supply curve (AS) shows the level of real GDP produced at different possible price levels. The Keynesian assumption assumes fixed product prices and wages. Changes in the aggregate demand curve cause changes in real GDP along a horizontal aggregate supply curve. When the aggregate supply curve is horizontal and an economy is in recession below full employment, the only effects of an increase in aggregate demand are increases in real GDP and employment, while the price level does not change. Stated simply, the Keynesian view is that “demand creates its own supply.” Keynesian theory rejects the classical theory’s notion of a self- correcting economy. Keynesians argue that during a recession, prices and wages do not adjust downward to restore an economy to full-employment real GDP. The classical economists believed that the economy was self-regulating and would correct itself over time without government intervention. It assumes that the economy operates at its full-employment output level and the price level of products and production change proportionally. When the aggregate supply curve is vertical at the full-employment GDP, the only effect over time of a change in aggregate demand is a change in the price level. Stated simply, the classical view is that “supply creates its own demand.” Economics 25  The AS has three distinct ranges or segments, labeled: Keynesian range Horizontal segment of the AS which represents the economy in a severe recession Intermediate Range The rising segment of the as which represents an economy approaching full- employment output Classical range Vertical segment of the AS which represents an economy at full employment Changes in AD-AS Macroeconomic Equilibrium At macroeconomic equilibrium, sellers neither overestimate nor underestimate the real GDP demanded at the prevailing price level. As aggregate demand increases in the Keynesian range, the price level remains constant as real GDP expands. In the intermediate range, there are several factors that contribute to inflation. Bottlenecks develop when some firms have reached their productive capacity while other firms operate below full capacity. A shortage of certain labor skills while firms are earning higher profits cause businesses to expect that labor will exert its power to obtain sizable wage increases. Wage demands are more difficult to reject when the economy is prospering because businesses fear workers will change jobs or strike. In the intermediate range, increases in aggregate demand increase both the price level and the real GDP level. Once the economy reaches full-employment output in the classical range, additional increases in aggregate demand merely cause inflation, rather than more real GDP. Nonprice-Level Determinants of Aggregate Supply The nonprice-level factors affecting AS include: Resource prices Technological change Taxes Subsidies Regulations Cost-Push and Demand-Pull Inflation Revisited Stagflation is the condition that occurs when an economy experiences the twin maladies of high unemployment and rapid inflation simultaneously. Cost-push inflation is a rise in the price level Economics 26  resulting from a decrease in the aggregate supply curve while the aggregate demand curve remains fixed. Demand-pull inflation is a rise in the price level resulting from an increase in the aggregate demand curve while the aggregate supply curve remains fixed. The business cycle is a result of shifts in the aggregate demand and aggregate supply curves. Economics 27