Economics for Educators Revised v 18G

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Ec o n o m i c s f o r Ed u c a t o r sRevised Edition

Robert F. Hodgin, Ph.D.Texas Council on Economic Education


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ii Economics for Educators, Revised

Copyright 2012Texas Council on Economic EducationAll Rights Reserved

Texas Council on Economic Education


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iii Economics for Educators, Revised

For Whitney, again



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iv Economics for Educators, Revised

Reviewers

Economic for Educators, Revised benefitted from many comments and suggestions from the reviewers listed alphabetically below.

Sally AdamsonRetired, Duncanville High SchoolDuncanville ISD

Michael ClarkBellaire High SchoolHouston ISD

Dr. Steve CobbUniversity of North TexasTexas Council on Economic Education Center Director

Dr. Steve Cotton University of Houston - Clear Lake

Dr. Alberto DavilaUniversity of Texas-Pan AmericanTexas Council on Economic Education Center Director

David PruittUniversity of North TexasTexas Council on Economic Education Consultant

Support

Laura EwingPresident, Texas Council on Economic Education

Allen RedingWebmaster, Texas Council on Economic Education

Catherine RinhartProgram Director, Texas Council on Economic Education


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Preface

I wrote this short primer to help K-12 educators prepare to properly teach economic ideas to their students. Economics provides auseful way of thinking about how the world works and its main themes deserve a rightful place in each students mindset. The mainthemesefficiency, trade-offs and opportunity costecho throughout the eighteen Microeconomic and Macroeconomic lessons.Written in plain language, each lesson orients the busy educator on the meaning and application of core economic terms, conceptsand tools. Other economic concepts then can be directly integrated with the more fundamental ones presented. It is my hope thatthe work enhances teacher knowledge and confidence, and then gets multiplied by the number of students they enlighten on thisuseful subject.

I thank the Texas Council on Economic Education for financial support to pen this revision. I also thank Laura Ewing, President of theTexas Council for her generous assistance, along with the academic and professional manuscript reviewers for their valuablecomments. Lingering errors remain mine alone.

Robert F. Hodgin, Ph.D. [email protected]

University of Houston - Clear Lake

Houston, Texas

Biographical Sketch

Robert F Hodgin, Ph.D., has taught economics to K-12 teachers, undergraduates and graduate students at the University of Houston-Clear Lake campus for four decades. His zeal for the subject radiates through presentations, academic articles, lay writingand consulting. Motivated by the rigid grade-level content demands imposed by state legislators, he penned Economics for

Educators, Revised Edition , to give teachers a very short and readable guide to the discipline. With a keen eye on commonmisunderstandings, he walks the reader through the major turns of the discipline in common language. With Economics for Educators, Revised Edition , a teacher can swiftly grasp a concept, develop a lesson plan and confidently address student questionsclass after class.


Robert and his wife, Johnette, have two grown daughters, Kristen and Whitney, and two granddaughters, Sloane and Elle. They liveon a lake near the Big Thicket area of East Texas.
mailto:[email protected]:[email protected]


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Table of Contents

Lesson 1: The Economic Problem 1

Economic Foundations 1

Economic Resources 1

Understanding Economic Behavior 2

The Economic Way of Thinking 3

Lesson 2: Goals of Economic Systems 7

The Economizing Questions 7

Comparing Economic Systems 8

An Economys Production Possibilities 9

Lesson 3: Wants and SubstitutesDemand 12

Economics Fundamental Divisions 12

Demand and the Search for Substitutes 12 Buyer Response to Price Changes 14

Demand Responses to Non-price Changes 16



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Lesson 4: Production Costs and the Division of Labor 19

Resources and the Pursuit of Profit 19 Diminishing Returns and Marginal Cost in the Short Run 19

Derived Demand for Factor Inputs 21

How Firms Grow in the Long Run 22

Lesson 5: Opportunity Cost and ChoiceSupply 24

Cost as Value 24

The Sellers Dilemma 24

Producer Choices and Supply 25

Seller Responses to Price Changes 26

Supply Responses to Non-price Changes 27

Lesson 6: How Markets Coordinate Exchange 30

Exchange Creates Wealth 30

Market Price as a Signal 30

Choices and Trade-offs at the Margin 31

Equilibrium Responses to Non-price Changes 32



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Lesson 7: Competition, Market Power and Economic Efficiency 35

Market Power and the Structure of Industry 35 Competitions Efficiency Promise 35

Monopolys Efficiency Failure 37

When a Few Firms Dominate the Market 38

Monopolistic Competition 39

Lesson 8: Economic Justifications for Government 42

Market Failure and Government 42

Government Provision of Public Goods 43

Government Regulation of Monopoly 43

Government Regulation of Common Resources 43

Private Goods with External Effects 44

Constitutional Right to Tax 45

Principles of Taxation 46

Fairness in Taxation 46

Tax Incidence and Efficiency 47

Lesson 9: Value, Time and Uncertainty 50

Time Preference and Present Value 50

Smart Investing in Any Market 51


Insurance as Risk Coverage 52


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Lesson 10: Consumer Economics 54

Life is a Marathon, Not a Sprint 54 First Paycheck 54

First CarSo Many Options 55

The Economics of Attending College 56

Credit Cards High Cost 57

First CareerLooking at the Long Run 58

First Home or Last HomeRent or Buy? 59

Planning Early for Living Long 61

Lesson 11: Gross Domestic Product and Growth 63

National Income Measurement 63

The Supply View of GDP 65 The Demand (Expenditure) View of GDP 65

Sources of Economic Growth 66

Economic Productivity and Well-being 67

How Technology Enhances Economic Growth 67

The Interrelatedness of Sectors 68

Lesson 12: Employment and Unemployment 71

Employment and Unemployment 71

Natural Rate of Unemployment 72

Curing Unemployment 72


Economics of Minimum Wage Laws 73


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Lesson 13: Money and Prices 75

Money 75 Measuring Inflation 75

Inflations Winners and Losers 77

Controlling Inflation 78

Lesson 14: Money and Interest Rates 80 Moneys Official Definitions 80

Money is Not Credit 80

Moneys Scarcity Preserves Its Value 80

Times Value is the Interest Rate 81

Lesson 15: Federal Reserve System 83

What Commercial Banks Do 83

What Central Banks Do 83

Money and the Federal Reserve 84

The Money Multiplier 84

Monetary Tools of the Fed 86



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Lesson 16: Macroeconomics: Long Run and Short Run 89

Macroeconomic Goals 89

The Long Run and Short Run 90

The Equation of Exchange 91

The Multiplier 92

Lesson 17: Fiscal and Monetary Policy 94 Laissez-faire versus Government Intervention 94

The Demand for Money 94

Monetary Policy Tools 94

Fiscal Policy Tools 96

National Debt and Fiscal Policy 96

Crowding Out Effect of Deficit Financing 97

Lesson 18 Gains from Trade 99

Trade and the Law of One Price 99

Comparative Advantage Theory 99

Currency Markets and Exchange Rates 101

The Balance of Payments 102


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Lesson 1: The Economic Problem

Economic Foundations Economic data are read daily by millions of people, yet many citizens hold mistaken notions about how the economy works. Sinceeconomic events affect everyone in some way, that statement suggests a gap in training, not a lack of relevance or interest. To beginconverting economic information into knowledge, this lesson introduces the economic problem then presents the economic way of thinking. Each subsequent lesson adds new economic concepts and useful applications, several with real data to demonstrate howeconomics works in free markets to enhance societys well being.

Economic activity permeates much of modern life, but achieving personal and social economic goals also requires effectiveinstitutions. For example, when a nations citizens feel secure from foreign invasion, perhaps through a strong national defense,borrowers more willingly undertake long-term investments using loaned funds. Well functioning courts, clear property rights, aresponsive political system, all support the operation of free markets to meet individual needs and achieve social goals.

Citizens in a democracy are free to choose from among the wide array of market-based opportunities, but achieving individual wealthor business success can be another matter. People have the freedom and the right to enjoy the rewards of legitimate commerce, butthey must accept that there is no guarantee of individual success or uninterrupted growth for society.

Economics the study of how society manages its scarce resources.

The Economic Problem how to meet societys material needs given scarce resources.

Good a product or service that provides value to its acquirer.

Free markets an exchange system for the production, distribution and consumption of goods and services between buyersand sellers.

Economic Resources

In economics, the productive means to address the economic problem fall into one of four all-encompassing categoriesland, labor,capital (machinery) and entrepreneurship. No matter the type of economic systemcapitalist, socialist or traditionalor the era,these four categories comprise the totality of economic resources. The compelling question is how a society is to organize andeffectively employ its resources.


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Economic resources and the market returns they earn:Labor earns wages from its human capitalLand earns rent for its productive applicationCapital (plant and equipment) earns interestEntrepreneurship (leading, organizing) earns profit

The US Bureau of Economic Analysis (BEA) measures resource payments to the factors of production each quarterthis is theincome view of Gross Domestic Product (GDP)as part of the National Income and Product Accounts (NIPA). Economists at theBEA, using official methodologies compile figures for each resource category, as shown below for 2009. Each category is a resourcebuilding blocka factor of productionfor making goods and services, and each, in return, earns payment for its use.

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

Natural (land) Rent $ 1,285.9Human (labor) Wages $ 7,811.7

Capital (physical assets) Interest $ 784.3Entrepreneurship Profit $ 1,258.0

Source: www.BEA.gov

Understanding Economic Behavior

Economists reduce market-based behavior to a set of logical relationships. They do so by distilling their observations on humanactivity down to a few measures in a cause-and-effect structure premised on assumptions. For example, most of us would agree thatpeople commonly act in the pursuit of their own self-interest. Many of the behaviors and assumptions economists employ may seemobvious, but when used to construct explanatory models, they can provide a rich understanding of peoples choice-making behavior.The better economists understand the roots of economic behavior under select conditions, the more able they are to define policiesto influence the economy and potentially improve the human condition.

Selected behavioral assumptions in economicsPeople desire a multitude of goodsPeople are willing to make trade-offs to be better off Not all people make the same trade-offsPeople respond to incentives


Why study theory? We cannot discover the cause and effect relationships at work in a complex society without theory. Economictheory attempts to explain human behavior by testing presumed logical relationships among economic measures. A proposed
http://www.bea.gov/http://www.bea.gov/http://www.bea.gov/


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Scarcity economic goods are not naturally available in the form, time or place desired without a cost or sacrifice.

Opportunity Cost when making a choice, it is the next most highly valued option forgone that measures the cost of thechosen option.

Trading-off making choices regarding the amount of one good sacrificed to get more of another good.

Neither individuals nor nations can have all the goods they want without making trade-offssacrifices occur at all levels to achieve adesired end. If the acquirer made a sacrifice to possess a desired good, then it must be an economic good by definition. To allocategoods to their best use requires an efficient production-distribution-consumption systemideally using prices determined in free andinformed markets. Efficiency means that people in the economic system make choices intended to make them better off.

Economists believe that most consumers make self-interestednot selfishchoices that improve their personal position. A personwill consume units of a private good up to the point where the expected additional costs equal, but do not exceed, the expectedadditional benefits. In doing so, the person maximizes his or her total net benefit. The steps and example presented below detailthat process.

Efficient economic choice making for a desired option means:Assessing the expected additional benefits and the expected additional costsChecking that the options expected benefit-to-cost ratio is greater than oneComparing the first options benefit-to-cost ratio to the next best optionThen, choosing the option with the greater net value, and sacrificing the other

As an application of efficient economic choice making, suppose that you have allotted $60 to purchase some nice casual T-shirts for summer. While shopping, you find a store where designer label T-shirts are on sale today only for $15 each. You think the price isa bargain. Ignoring sales taxes, how many T-shirts will you buy?



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Suppose the blue bars in the chart above reflect the personal value that you place on each T-shirt you might buy, beginning with thefirst one. Notice that you feel willing to pay as much as $30 for that T-shirt, well over the sale price. The value-to-cost ratio is certainlypositive; 2-to-1 ($30 value/$15 cost). Also notice that as you anticipate purchasing each additional T-shirt, their value to you falls (justhow many nice summer T-shirts does one need?). Will you purchase the first T-shirt? Yes.

At the same price, what is the benefit-to-cost logic for the second T-shirt? Well, the cost is the same$15. But the value to you hasfallen to about $25. You still feel the value is greater than the costand besides, the sale ends today. So you purchase that onealso. Would you purchase the 3 rd T-shirt? Yes, again. Your perceived value of about $20 is still greater than the cost of $15. Nowwhat about the 4 th T-shirt? Here you are indifferent, at the limitand in two ways. First, the value just equals the cost for the T-shirt.Second, you will have spent precisely all the money you allotted from your budget for the total T-shirt purchase.

The action described above is smart economic choice makingthey are decisions made at the margin. What does that mean?You optimized the use of your scarce funds by individually assessing the benefit and the cost, and purchased the most T-shirtspossible given their price and your budget. That means for each additional (i.e. marginal) T-shirt you considered its cost compared toits valuemaking sure that the value exceeded the cost, up to the count of T-shirts that used all funds allotted. In the end, youmaximized your total net benefit.



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In Sum

Economics is the study of how society allocates scarce resources among competing options.The economic problem is how to satisfy the material well-being of people in the society.Scarcity means that economic goods have a cost in the form of the value sacrificed to acquire the desired good.Economic resources fall into one of four categories: land (earns rent), labor (earns wages), capital (earns interest) andentrepreneurship (earns profit).Economists believe that theory provides understanding of citizens behavior toward solving societys economic problem.Opportunity cost is the value of the next best option foregone when a more attractive option is chosen.Making trade-offs involves sacrificing some of one good to get more of another good, so that total benefit rises.Economic efficiency means making rational benefit-cost choices in the consumption, production and distribution of goods.


An action is economically efficient if a person makes choices where the net benefit (expected additional benefits less theexpected additional costs) is positive or rejects choices where the net benefit is negative.


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Governments goals in a market systemProtect citizens freedom to choose between opportunitiesSupport efficient markets through competitive pricesMaintain equity and a sense of fairness in dealingsEnsure security and stability to support risk taking

There is no compelling evidence that market-based economies naturally evolve from tradition or command systems. Free marketsrequire political support, legal validation, social acceptance and institutional structures. The transformation from traditionaleconomies, like India, or from command economies, such as the former Soviet Union, to a market system can be fraught withuncertainty and social upheaval.

An Economys Production Possibilities

No matter the chosen economic system, every country addresses the three economizing questions when bringing scarce economicresources into their desired use. No nation, however wealthy, can make economic choices without sacrifices. As the systemallocates its scarce resources it must make trade-offs when producing goods to meet societys economic needs. A ProductionPossibilities Curve shows both the production limits and opportunity costs of resource trade-offs when a society produces two or more goods in a given time period, with fixed current resources and unchanging technology.

Production Possibility ExampleIn One Day: Widgets Gadgets Ann makes 10 OR 5 Ben makes 6 OR 6 Cal makes 2 OR 4


Consider a simple economy with just three people (Ann, Ben and Cal) and two product sectorsWidgets and Gadgetsboth sociallyuseful. To begin, one question is the order of hiring into each sector. For example, who makes gadgets at lowest cost? Since nomoney values appear in the table above, how can the answer be motivated?


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Should we hire Ann first to make gadgets? No. Hiring Ann first overlooks the economic basis for efficient choice makingopportunitycost. To see how, notice in the table that for every one gadget Ann produces each day, it costs her, and the society, 2 widgets not produced (10 widgets divided by 5 gadgets = 2 widgets lost per gadget made). Instead, can you see why Cal should be hired firstto make the first 4 gadgets (where his gadget costs only a widget not made)? Its true. Using this same opportunity cost logic Benwill be hired second, where his opportunity cost of making 1 gadget is 1 widget. Finally, Ann should be the last hire, since her relativegadget-making cost is highest of the three (each of her gadgets costs 2 widgets not made).

The same logic applied to making widgets will find the hiring order precisely reversed. How is this so? Look at Ann again, for her 10widgets made per day, only 5 gadgets are sacrificedso a widget costs just half a gadget in production foregone. That cost is lower than either Cal or Ben in widget making. For Ben each widget made by him costs one gadget, while for Cal each widget costs twogadgets. Notice that when opportunity cost prevails as the criterion to determine the hiring order for either good, the least costly(opportunity cost, again) person is hired first and the most costly person is hired last. More, since society likely wants both widgetsand gadgets at least one person will make the opposite good. Should it not be the last person hired in one sector (the mostexpensive and least efficient) who transfers to the alternate sector, where they can become a more efficient (less costly) maker in theother sector? Yes and their world will be better off for that.



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13 E i f Ed t R i d


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Demand the quantity of a good or service that buyers are willing and able to purchase at a range of prices, all other marketforces held constant.

The definition of demand implies that potential buyers assess the prospective benefits from consuming a good compared to what itwill cost. This statement is only half-right. Good economic decision-making always poses pairs of options. The first option is theoffer immediately at hand. The second option is the next best offer known to be available, given its price and perceived benefits. Bychoosing one, the consumer sacrifices the other on the expectation that the benefits-to-cost assessment for the chosen option will

deliver greater net satisfaction.How is it that the definition for demand presumes a range of prices for a given good? In any particular store, most Americanshoppers see only one price. Here, the economist makes two more mental assumptions: other vendors prices for the same or similar good are known, at little cost, and travel in the market place is free and fast. These useful assumptions let the buyer efficiently select the product from a potentially wide array of vendors and range of prices then available.



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Demand Responses to Non-price Changes

Demand analysis for an individual buyer and demand analysis for an entire market of buyers are quite similar. This is true because amarkets demand is the sum of the amounts demanded at every price by all buyers in the market. While the behavior of a singleindividual in the market may vary in magnitude from other buyers, the market demand curve still slopes downward and to the right.

The definition of demand contains a phrase that reads all other market forces held constant. We have seen above that when time isartificially constrained, price changes bring about a change in the quantity demanded, noted by reading along a fixed-in-placedemand curve. As you likely have suspected, other forces are at work in the market.

Inspect the chart above. Choose a price on the vertical axis, say $10, then read horizontally across to the right edge of the bright blue demand graph and read the quantity demanded; 30 units. If demand INcreased from that point and shifted rightward (like thegreen arrow) to the outer edge of the lighter blue graph, the number of units demanded at the original price would be larger, nearly 40units. That is an increase in demand, current price held constant.

Again, select a price on the axis, say $40, then move horizontally across to locate the outer edge of the light blue demand graph andread the quantity demanded; about 20 units. If demand DEcreased from that point by shifting leftward (like the red arrow) to the edgeof the bright blue graph, the number of units at the original price would be smaller, about 15 units. That is a decrease in demand.



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,

Law of DemandThe inverse (or opposite in direction) relationship between current price and the quantity demanded.Demand curves slope down and to the right due to the:

o Income effect where price changes affect buyers purchasing power, ando Substitution effect where buyers move toward less expensive substitutes and away from more expensive substitutes

Current price changes for a good bring about changes in the current quantity demanded, as read along a given demand curve.Price Elasticity of Demandmeasures of consumers relative quantity response to a relative change in current price. Three maindeterminants of demand elasticity are:

o Closeness and availability of perceived and known substituteso Passage of time allowing for more substituteso Goods price as a percent of buyers income

Non-price market determinants shift the demand curve, over time, reflecting changes in quantity demanded at all priceso

Increase in demand is a rightward shift of the demand curve in price quantity spaceo Decrease in demand is a leftward shift of the demand curve in price quantity spaceNon-price market forces that shift the demand schedule, current price held constant, include:

o Number of buyers: more buyers in the market increase the demand (shift to the right) and the opposite is trueo Buyer tastes: customers liking more of the good increase the demand (shift to the right) and the opposite is trueo Buyer incomes: higher income increases demand for normal goods (shift to the right) and the opposite is trueo Future price expectations

If consumers expect future prices to rise, they buy more of the good now, increasing demand (shift to the right).If consumers expect future prices to fall, they will buy less of the good now, decreasing demand (shift to the left).

o Price of related goods:Complementsif the price rises for a good that complements the original good, the demand for the original goodfalls (and the opposite is true).


Substitutesif the price rises for a good that is a substitute for the original good, the demand for the original goodrises (and the opposite is true).


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Derived Demand for Factor Inputs

The business owner seeks and allocates productive resourcesfactors of production: land, labor and capitalbecause she needsthem to meet the demand for the good or service offered by the business. Efficiency dictates that a match of capabilities be achieved

using the productive resource inputsphysical with human capitalat the least possible cost.

The owner must determine both the skill mix and number of people to hire. The prevailing market wage for the type of labor skillssought provides a good measure for labor costs. The market wage rate multiplied by the number of positions required per productioncycle (time) determines the total wage cost for the firm.

Crucially it is product demandthe number of units demanded per time multiplied by the market pricethat provides the ability topay for the labor services. That is why economists call the demand for factor resources a derived demand .

Derived demand the relationship between the resource factor's price and quantity wanted by firms directly depends onmarket demand for the final product(s) the factor helps produce.

So how many input units of each type will be hired? The economists rule is to hire input factors until the cost of the last unit acquiredor last hour workedthe wage rate times the last factor input hired or last hour workedjust equals the value of its productionproduct price times the additional output units produced. Yet another marginal efficiency rule that helps generate profits by keepingvariable costs low.



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Lesson 5: Opportunity Cost and ChoiceSupply

Cost as Value

There can be no choice made without a sacrificea cost. By selecting one purchase option over another or one job opportunity over another, the person making the choice implicitly reveals their preference and their values. This view reflects the fundamental ideathat all costs in economics are opportunity costs.

Opportunity cost -the value of the next best option foregone when making a choice.

The Sellers Dilemma

Decisions made and actions taken today always are based on expectations about the future. Sellers assume some risk whenproducing what they believe buyers will purchase ahead of the actual sales transaction. The sales price, at least by expectation,must be sufficient to cover all the costs of production and sellingopportunity costs. So what is it that makes a businessproposition sufficiently attractive for a potential seller to undertake? The quick response in a market system is the reward of profit.But that response leaves out too much economic detail.

To price a good or service, the producer first assesses the competition (the buyers options) then figures the sales volume per time toderive the total (opportunity) cost of the required resources. If that cost is equal to or below the price a particular buyer is willing topay, then production can be fruitful for the seller. If the negotiated price less the estimated opportunity costs for the requiredeconomic resources is both positive and greater than the next best use of the sellers time, the proposition should be profitable.

Prior to taking action or making a decision, all costs are anticipatory or avoidable, because they have not been incurred. That is thesellers decision point. Once the decision is made to proceed with the one option (and forsaking the next best option)perhaps bytaking out a loan, acquiring assets or contracting for labor, the prior estimated costs become real. This fundamental economic logicreduces to the relationship below.

Economic Decision Making -Choose the option where the expected additional benefit to additional cost ratio is greater than that same ratio for the next best choice.

Additional Revenue Option A < ? > Additional Revenue Option B Additional Cost Option A Additional Cost Option B




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Profit is the reward for successfully operating a business in an uncertain market environment. The economists logic to maximizeprofits suggests that competitive sellers produce up to the point where market price covers all opportunity costs of production, whichincludes sufficient profit to retain the seller-entrepreneur in that line of work. If market price rises, a supplier operating at less than full

capacity would willingly increase production, as long as the increased per unit cost is less than the new market price. Doing so addsto net profit. That is why market supply curves generally rise up and to the right, as the next section reveals.

Producer Choices and Supply

Demand from buyers elicits supply from producers. And supplying a product is feasible when the buyers maximum willing purchaseprice exceeds the sellers minimum willing offer price. Each firms production cost is a competitive factor so much effort is spentkeeping opportunity costs of production low. A seller who offers output below its opportunity cost is not being rational, because therevenue would be insufficient to pay the total opportunity costs of production. Production cost differences exist between sellers, evenfor a similar product. So goods produced for market get offered at a range of prices, each price covering the respective firmsanticipated opportunity cost.



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Supply Responses to Non-price Changes

Supply analysis for an individual producer and supply analysis for an entire market of producers are similar. This is true because a

markets supply is the sum of units supplied, at each and every price, by the sellers in the market. While the behavior or response of a particular seller in a market may occasionally vary from that of all sellers as a group, the total market supply curve commonlyslopes upward and to the right.

Recall that the last phrase in the definition of supply is all other market forces held constant. What is the meaning and importance of this phrase? You have seen when time is artificially held still, that price changes bring about a change in the quantity supplied, notedby reading along a fixed-in-place supply curve for the short run. Just as you suspected in the lesson on demand, forces other thanprice also are at work in the supplier market.


Inspect the chart above. Choose a price on the vertical axis, say $40. Then read the quantity supplied at the left edge of the yellowsupply line. It is about 50 units. If supply increased, by shifting to the right, to become the blue supply line, the number of unitssupplied at the same price of $40 would be about 55 units. Thats an increase in supply, at the same price. Had we begun with theblue supply line at the price of $40, a movement back to the yellow supply line would have represented a decrease in supply. Forcesthat increase supply shift the curve to the right. Forces that decrease supply shift the curve to the left. Economists categorize theforces that move or shift market supply. As non-price market forces influence sellers, the actual supply curve position changesthrough time. Non-price forces on supply are factors that cause a change in supplya shift of the supply curvewithout a change in



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the current price for the product. A change in supply means that, at any and all prices, a different quantitygreater or lesser thanbeforeof the good will be supplied.The reason for the emphasis on the difference between changes in quantity supplied brought about by changes in the current price of

the good versus shifts in supply caused by other market forces is the same as for the demand discussion and bears repeating. Thisdistinction, the time-based separation of price from other market forces, lets the careful thinker correctly understand how the supplyside of the market works. The supply determinants and the logic for how to determine the direction of their influence on the supplyschedule appear below.

Supply determinants: factors that shift the supply curve (with no change in price) Number of sellers as the count of sellers rises, the supply increases (and the opposite is true) Technology as technology is adopted, the supply increases (and does not decrease) Future price expectations if future market price is expected to rise, current supply falls (and the opposite is true) Input costs if the costs of material and labor rise, the supply decreases (and the opposite is true)

How to Analyze the Effect of Determinants on SupplyStep 1: From the facts provided, determine which supply force is affectedStep 2: Determine the direction of the force itself: increase or decreaseStep 3: From the direction of the force and knowledge of economic incentives, determine thedirection of change for the supply curve: increase (rightward shift) or decrease (leftward shift)




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In Sum

Cost means the opportunity costs of resources in use, reflected by the owner-made choices of each economic resource.Opportunity cost is the value of the next best option foregone.A seller-entrepreneur decides if an opportunity is a good business proposition by:

o Assessing expected net profits from a ventureo Comparing the first options net benefits to the next best alternative

Business ownerssellersmust pay a resource opportunity cost to attract them into a particular use.Revenue left after paying resources their opportunity costs becomes profit for the entrepreneur-seller.Supplythe quantity of a good that sellers are willing and able to offer at a range of current pricesother market forces constantLaw of Supplysellers will produce more of a product for sale at a higher current price than at a lower current price.Price elasticity of supplyA measure of proportionate producer output response to a relative change in current price.

o The main determinant of supply elasticity is time and the ability to direct resources to different usesNon-price market forces shift the supply curve, as time passes, to reflect changes in the quantity supplied at all prices.

o Increase in supply is a rightward shift of the curve;o Decrease in supply is a leftward shift of the curve;

Number of sellersas the count of sellers rises/falls, the supply increases/decreasesTechnologyas technology is integrated, the supply increases

Future price expectationsif future market price is expected to rise/fall, current supply falls/risesInput costsif the costs of material and labor rise/fall, the supply decreases/increases



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The lower the transaction costscosts of arranging transactions between buyer and sellerthe more efficient is the market. Theclearer and more accepted the property rightswhat belongs to whom under what circumstancesthe more efficient is the market.You can see how the efficiency mantra pervades all aspects of production, exchange and distribution in economics.

Choices and Trade-offs at the Margin

To the untrained eye, market processes can appear chaotic and directionless. Using economics fundamental division, buyers versussellers, then separating time into current and future periods, allows market dynamics to make sense. In the chart below, marketdemand (in blue) slopes down to the right and market supply (in green) slopes up to the right, the two lines cross at a quantity of 5units.

To the right of their intersection, both curves are dotted to suggest that no transactions can occur there. The only area wheretransactions can logically occur is in the reddish-silver triangular area bounded by the solid blue upper range of the demand curveand the solid red lower range of the supply curve up to their intersection. Why is this so?

The reddish-silver triangular area is the only place where a potentially negotiable price is both below the maximum demand price for some buyers and above the minimum opportunity supply cost for some sellers. Buyers know their maximum value price for a goodand wish to pay that price or less. Sellers know the minimum opportunity costs of bringing the good to market and wish to get thatprice or more.



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Inspect the chart above. See how the current market demand schedule (in blue) and the current market supply schedule (in green)together determine the market equilibrium Price (= $5) and quantity (= 5 units) for a good. Now suppose that buyers believe thefuture market price of the good will increase, and that sellers perceive the same thing to be true. What will happen to marketequilibrium priceand why?

Step 1: How to shift demand? Recall when buyers believe prices will rise in the future they tend to buy more now, at all current prices.That is an INcrease in demand, a shift to the right from the blue demand to the dotted blue demand curve, labeled B.

Step 2: How to shift supply? Suppliers will want to restrict current supply (if the good is not perishable) and sell later at the higher

expected price. That is a DEcrease in supply, a shift to the left from the green supply to the dotted green supply curve labeled A.Step 3: What is the effect on equilibrium price and quantity? The blue demand has increased to the now higher demand (more unitsare demanded at each price) labeled B. The green supply has decreased to the now lower supply (fewer units are supplied at eachprice) labeled A. The increased demand and decreased supply together raise the market equilibrium price to $7 and lower theequilibrium quantity to 4.5 units. When both demand and supply shift, it is necessary to work through the logic to correctly determinethe effect on the resulting equilibrium price and quantity in the market.




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In Sum

Trade creates wealth because both parties perceive a gain in a voluntary exchange.

An economic good provides wealth only to someone who values it.A market exists anywhere an exchange transaction occurs.The forces of supply and demand working together efficiently determine market equilibrium price when:

o Competitive markets tend toward an equilibrium priceone that clears the market, ando Many buyers and sellers exist to bargain freely when market information and mobility costs are lowo Property rightswhat belongs to whom under what conditions are known and respectedo Transactions coststhe costs of completing a transaction are low

Efficient markets in economics means:o Goods are produced at their opportunity cost and exchanged for their perceived valueo Goods flow to their highest valued useo Market exchanges occur when the buyers maximum willing price exceeds the sellers minimum offer price.o Market equilibrium is a tendency where the exchange price for the last buyer and last seller in that market are equal.

Non-price market forces shift either the demand or supply curve and alter the market equilibrium price and quantity. Starting froma given demand and supply intersection with a given equilibrium price and quantity, the following are true:

o Increased demand (supply constant)a rightward shift, increases both equilibrium price and quantity.o Decreased demand (supply constant)a leftward shift, decreases both equilibrium price and quantity.o Increased supply (demand constant)a rightward shift, decreases equilibrium price and increases equilibrium

quantity.o Decreased supply (demand constant)a leftward shift, increases equilibrium price and decreases equilibrium quantity.


o Mixed movements in demand and supply must be determined using the facts in the problem statement. Equilibriumprice and quantity can rise, fall or stay the same.


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Inspect the chart above, and notice that equilibrium market price equals $20any sellers revenue per unit. Further note thatopportunity cost rises as production increases. In this situation, a rational seller will gladly produce up to 4 units per period for sale.

Why? Each unit of output up to the 4th

unit sells at a price above its opportunity cost and adds to profit. To produce beyond thatpoint, say the 5 th unit is not rational because its cost ($25) is greater than the market equilibrium price received ($20) and lowersprofit.

So the optimum output rate, the one that will generate the most profit, if profits are being made, is 4 units. How could it be that theseller might not be making a profit if each unit sells for more than its opportunity cost? In the chart above, the amount of overheadcost was not provided. Once known, short run profit determination can be made.

Profit maximizing rule operating at the level of output where market price equals marginal cost will either maximize profitsor minimize losses, if they are incurred.


The competitors rule is to produce at the level of output where price equals marginal cost , the opportunity cost of production. Bydoing so, any profits will be maximized or any losses will be minimized. This extreme competitive pressure guarantees private goodsbrought to market will sell for a price equal to marginal costthe opportunity cost. Further, there will be more product available atthat price than would be available through any other market structure. These results reflect competitions efficiency promise for private goods in the short run. In the long run the efficient firms best able to sustain profits by controlling cost can survive and grow.


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Games like this are common among the rivals in oligopoly industries. Often, there can be tacit collusion where the largest rival willact the part of a price leader and move first to change price, with the expectation that others will quickly follow. Airline route games of this sort have revealed a more sinister side in recent years as rivals have sometimes refused, between holiday peak pricing periods,

to follow their price leader, to the detriment of the leaders profit.Monopolistic Competition

Moving farther away from the monopolistic and closer to the pure competition end of the competitive continuum, we find industriesblending elements of both competition and monopoly. Example industries include dry cereal, mens and womens clothing, hotelsand many other retail products. Entering or leaving this industry is relatively less expensive than for oligopoly industries.

The relatively large number of firms in monopolistically competitive industries still allows some degree of price setting powertheir individual demand curve slopes down to the right. Rival firms engage in stiff competition based on product feature similarity, location,advertising affects and other strategic economic dimensions. For these firms, significant resources are applied to the marketingfunction. Marketing includes all activities between product production and customer purchase as a legitimate cost of productpositioning.

Components of marketing as strategic toolsAdvertising Distribution activitiesTransportation and storage Product planning

Market research Customer serviceFinancing Product design

CharacteristicPure

CompetitionMonopolisticCompetition Oligopoly Monopoly

Price setting power None Little Some MuchProduct similarity Identical Similar/Identical Similar/ Identical N/A

Price to opportunity cost Equal & Ideal Price above Price above Price far aboveExcess capacity None Some Some Much

Advertising None Much Much LittleMarket entry cost Zero Modest High Great

Information access Total Modest Limited Limited



M li i ll i i fi d d d i d d d h l f i l d f h i


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Monopolistically competitive firms product demand curves are interdependent due to the closeness of rival product features to their own. A price decrease for one firms product can lower the demand for a close rival as the rival products customers opt out in favor of the now less expensive and not-that-different substitute, for example frozen turkey dinners instead of frozen chicken dinners.

A similar demand response is possible from successful advertising campaigns. If one firm aggressively advertises customer-important features, buyers may leave the rival products market to join that of the newly perceived better product. Televisioncommercials often mention the name of the closest rival and compare selected features. The economic objective of all advertising isto increase demand for the one producta rightward shiftand to make the demand inelasticless responsive to a rival producerscampaign in the market place.



In S m


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In Sum

Economics strongly favors competitive markets because forces work to bring equilibrium price down to opportunity cost and to

provide more output than any other market structure. Competitive market characteristics include:o Very many buyers and sellerso Identical goodso No market entry or exit costso Costless market information and mobility

Competitive markets efficiently achieve an equilibrium price and quantity that clears the market.o They are powerless price takers and must accept the markets price as their own as they seek to maximize profits.o They produce output up to the point where the market price just equals the opportunity cost of the last unit produced.

Monopoliessingle sellersface a downward sloping demand curve for the entire market comprised of many buyers.o To sell more the monopolist must lower price.o Monopolies are economically inefficient since:

Their market pricing power lets them search for the price that maximizes profits, andAt the monopolys profit maximizing price:

Output is lower than for a competitive market Price lies above the opportunity cost for the output

Because output is inefficiently allocated monopolies represent a form of market failure.Oligopoly industries contain many buyers and several rival firms with interdependent product demand where strategic pricing

and production games are common.o Large market entry and exit costso Competition can be on the basis of price or output depending on the nature of the good.o Advertising is common when rivals produce similar goods with differing features.

Monopolistic competition represents an industry with many sellers and very many buyers.o Market entry and exit costs are lowo Product differentiation is used to gain market shareo Advertising is a strategic tool designed to:

Increase product demandshift rightwardDecrease product demand elasticity


All less-than-competitive industry structures are relatively inefficient compared to pure competition and prevent society fromreceiving the full value of additional production and lower product price.


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Private Goods with External Effects


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Private Goods with External Effects

Private markets trading private goods often do achieve a socially optimal solution, without government intervention. So under what

circumstances should government intervene in markets for private goods?

Externality Types and Market ConsequencesExternality Type Supply of Good

from Societys View Externality Type Demand for Good from

Societys View Production :

Positive Society wants more of the good than isproduced by sellers (e.g. R&D)

Consumption :Positive

Society wants more of the good than isconsumed by buyers (e.g. vaccinations)

Production : Negative

Society wants less of the good than isproduced by sellers (e.g. coal power)

Consumption :Negative

Society wants less of the good than isconsumed by buyers (e.g. heroin)

Private goods, when produced or when consumed, may unintentionally impose benefits or costs on a party that is neither thepurchaser nor the producer. In short, externalities affect someone external to the transaction. For example, if Mary buys a pack of cigarettes from a machine in a restaurant and smokes it, the smoke is a negative externality imposed on other diners. Or, if Robertpays landscapers to plant a beautiful garden in his front lawn, the garden is a positive externality enjoyed by his neighbors.

A now famous proposition put forth by Ronald Coase at the University of Chicago, says that if property rights are clearly defined, thetransactions costs of bargaining are zero, and the affected parties are willing to bargain, efficient market-based resolutions can beachieved when the parties negotiate compensation or agreed upon restrictions.

The Coase Theorem states that if private parties can bargain without cost about how to allocate resources, then they canresolve the externality problem on their own.

Property rights limits on the use of private property, goods and services that help define the limits of social behavior.

Transactions costs the costs of negotiating a transaction with all relevant parties.



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Coases Theoremstates that if private parties can bargain without cost about how to allocate resources, then they canl th t lit bl th i


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resolve the externality problem on their own.Tragedy of the commonsfree common resource overuse, where all citizens have access but no single user directly pays,diminishes the use value for all as the tragedy of the commons.Two categories of economic goods

o Public Goodconsumption by one person does not diminish the amount available to another person, and otherscannot be excluded from its consumption.

o Private Goodonly the consumer enjoys the benefits of consuming the good and the act of consumption reduces thegoods availability to others.

Taxation principleso Benefits received principle of taxation says that people should contribute taxes in some proportion to the benefits they

receive.o Ability to pay principle , says that taxes should be levied so that those who earn more pay proportionately more.

Tax policy fairnesso Horizontal equity means that taxpayers with a similar ability to pay should pay a similar amount in taxes.o Vertical equity means that tax payers with greater ability to pay should pay larger amounts of taxes.

Free rider a person who receives benefits from a public good or from others decisions regarding a public good, but whoavoids paying for the benefit.Tax incidence the party who ultimately pays the tax, always a person or group.Tax efficiency the nature and size of the market distortion from a given tax.Tax burden on income, types:

o Regressive; taxation where there is a greater percentage burden on lower income levelso Proportional; taxation where there is an equal percentage burden on all income levelso Progressive; taxation where there is a greater percentage burden as income level rises



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Health insurance covers health and disability expenses according to a detailed listing of medical maladies. As an employmentbenefit, employers commonly provide health and disability insurance coverage using third party providers. Rising premiums in recent


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, p y y p y g g p y p g pyears have forced many employers to either reduce their health insurance coverage or share the premium cost with their employees.One way to reduce premium costs for health and property insurance is to maintain high deductibles. A deductible represents the firstdollars of coverage in the event of a loss. Essentially, the policyholder self-insures the first several hundred dollars or more of eachclaim.

Property insurancehome, auto, business propertycovers tangible asset damage to the insureds property by others or certainnamed events such as fire. For consumers whose homes are mortgaged or cars financed, it is common for the third partybeneficiarythe lenderto insist on some minimum property insurance coverage. That way, the financier as well as the home or car owner is protected in the event of a loss.

In Sum

Time has a value and your personal time preference is reflected in your personal behavior.o If you spend all your income and save nothing, you do not value the future very highlyo If you save and earn 5 percent a year, then you value the future and can accumulate wealth

The power of compound interest versus simple interest is very large and should be used to full advantageInvesting in uncertain times can be made less risky by diversifying the types of investment heldWork to achieve a positive balance between net earnings and current expenses throughout life.Pay yourself first in the form of regular monthly savings.Purchase insurance to minimize the risks of loss to the extent affordable, based on your financial needs.

o Life insurance protects against lost income for your survivors.Term life covers insurance costs only and is less expensive than whole lifeWhole life insurance accumulates value at a certain rate and is more expensiveHealth insurance pays for illness or accident via detailed specified coverage, but not loss of income.


Property insurance covers damage to physical assets caused by you or others.


Lesson 10: Consumer Economics


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Life is a marathon, Not a Sprint

Fulfillment in life has many dimensions. This lesson focuses on those economic aspects of life over which most people can exercisesome degree of choice. An adage in business states that its not what you earn but what you keep that matters. The same holdstrue for individuals. Though some may challenge the extent of that influence, American citizens possess far more choice-makingopportunities than do people in other countries. We might say our personal economic problem is how to freely and legally achievethe most from the economic dimension of life.

During normal times, average US households spend 95 percent of their annual after-tax income. Because our material wantsoutstrip our financial means much of the time, that reality forces most citizens to economize. But even work is a choice in America.We are motivated to work by the income benefits it provides. And for nearly every occupation there is a life-cycle profile of earnings.Early career income is relatively low, rises then peaks in the middle 50s and slowly declines until retirement, yet another life choice.So if we take the very long view and ask how we want our golden years to be, the importance of how much personal income andwealth we earn and keep becomes clear.

First Paycheck

Somewhere between the ages of 16 and 19 many teenagers enter the job market for the first time. That is where the world of work

and the lure of consumption merge and conflict. Current federal minimum wage in 2011 is $7.25 per hour. Full-time students workingno more than 8 hours a day and not more than 20 hours a week can legally be paid as little as 85 percent of the minimum wage$6.16 per hour. Using the full federal minimum wage rate and a 20-hour work week for a student, the table below estimates weeklytake-home pay, after basic payroll deductions.

Part Time Job Weekly Paycheck ExampleAmount

Gross pay per week: $7.25 X 20 hours $145.00

Federal income tax withholding: 10% 14.50Social Security/Medicare: 7.65% X $ 11.09Basic insurance plan premium 10.00

Weekly take home pay $109.41



Notice that our part-time employed student receives only about 75 percent of his or her gross wages in take-home pay. The exampleassumes the student has few material tax deductions, uses tax rates based on the 2010 tax year and that the company requires


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contributions to a basic group insurance policy.

A few hours after our teenager picks up their first paycheck often is a good time for parents to explain why net income (75%) is somuch smaller than gross income (100%). Few employed persons are exempt from contributing toward their estimated tax liability,basic social programs or medical insurance.

The ability-to-pay justification for taxesthose who earn more can pay moreis built into the US federal income tax structure, as the2011 tax table below on single filers ordinary taxable income reveals. Insurance, while a seemingly unnecessary cost to a healthyteen, provides medical coverage in the event of an accident or illness. Yet, $109.41-per-week take-home pay seems to disappear quickly, even though there are relatively few hours left after school and work obligations.

Prospective US Earnings Tax Rates 2011Tax Rate 10% 15% 25% 28% 36% 39.6%

Single Filer Under $8,525

$8,525 $34,650

$34,650 $83,900

$83,900 $194,150

$194,150 $380,500 Over $380,500

Source: www.IRS.gov

First CarSo Many Options

Nothing represents freedom to an American teenager so much as their first car. As a virtual right-of-passage, and whether its a shinynew one or a dented used one, it places nearly unlimited mobility and opportunity into the hands of its youthful driver. As with allmaterial fascinations, this one too has an anchor in hard reality. The thing just costs a lot of money.

To give our teen a taste of adult responsibility, most parents want their driving child to help support the 4-wheeled chariot. Some

insist their child bear the total financial cost of car ownership. The table on the next page divides representative monthly automobileexpenses into two categories; fixed and variable. The example assumes the car, a used 2006 Honda Civic, is financed for 4 years.



Sample CAR Ownership Costs/MonthFixed Expenses
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pCar note $280

Insurance $125Annual Registration by month (= $84/12) $7Annual Inspection by month (= $48/12) $4

Sub-total Fixed $416 Variable Expenses Gasoline $120Maintenance $25Parking $10Accessories $35

Sub-total Variable $190 Total Car Costs/Month $676

Even if we suppose that our driving teens parents are financially able and willing to cover the fixed expenses of owning the vehicle,variable expenses still total $190 monthly. If our teen is the same one from the example above who nets $437.64 per month($109.41 per week X 4) from their 20-hour per week minimum wage job, they have just under half ($247.64) left for dating andpersonal purchases. If the parents insisted their teen pay for the car insurance, spendable monthly earnings would be $122.64. Notmany expensive dates possible there.

The Economics of Attending College

The strong and positive relationship between education and earnings is hard to over-state. The national data in the table on the nextpage are compelling. Completing four years of college opens doors to opportunities not available through any other social institution.National studies using sound methodologies confirm that investing in ones own human capital may offer the greatest long-termbenefits of any personal investment. Education also returns dividends to society in the form of economic growth. That is one

economic reason why the federal government offers direct loans and grants to willing and qualified candidates to complete their college education. Even with tuition costs rising, the rate of return on training and educational investment is high.



US Median Earnings Over Past 12 Mos. 2005-2009Population 25 years and over with earnings $34 159


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Population 25 years and over with earnings $34,159Less than high school graduate $19,420High school graduate (includes equivalency) $27,272Some college or associate's degree $33,457Bachelor's degree $47,747Graduate or professional degree $62,708Source: www.Census.gov . * 2009 inflation-adjusted values

Credit Cards High Cost

There is an almost irresistible allure to reach into our expected future income and use some of it for current purchases. Hard realityalso attends the act. First, the borrower will have to pay for the privilege in the form of interest, often at an unconscionably high rate.Second, the borrower is contractually committed to pay back the principal and the interest from expected future income, whether or not expectations about the future incomes size come true.

Credit Card A short-term loan agreement that enables holders to enjoy goods and services today by borrowing againsttomorrows income for a fee called interest.

When should a consumer borrow money? The best response is when current income is insufficient to cover an unexpected expenseand there is room in expected future income to repay the loan with interest. If living expenses exceed income every month, creditcard coverage for the difference is a very poor choice, serving only to postpone an inevitable and bad end. Monthly expenses mustsomehow be reduced or monthly income enhanced. Ultimately, using credit cards, or any borrowing instrument, in this fashion onlyadds misery to an already serious personal financial situation.

The credit-seeking customer should shop for credit lending rates, just as they would shop the price of any economic good. Card-

issuing companies set rates according to each customers credit profile: lower rates for good paying customers and higher rates for customers with a poor history. Commercial credit counseling firms offer services to those needing advice.

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Average Yearly Expenditures for USConsumer Units 2007-2009


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Category Amount Percent

Food $6,372 12.9Housing $16,895 34.4Transportation $7,658 15.6Apparel and services $1,725 3.5Healthcare $3,126 6.3Entertainment $2,693 5.5Insurance and Pensions $5,471 11.1Other expenditures $5,127 10.4

Totals $49,067 100.0 Source: www.BLS.gov

A typical US workers career income path shows income rising as a trend through their late 40s to mid-50s. Thereafter income tendsto level off or even fall slightly through age 65. In the early career years there is much pressure to spend on family needs. Settingones sights on a distant retirement date is hard to do during the child-rearing years. Yet, the benefits of following a consistentpersonal savings program are economically profound.

Contemporary job market studies indicate that the average worker will change jobs at least five times in a career and the rate of jobturnover is rising. Coping with change of that magnitude requires sticking to a personal wealth accumulation plan. The secret lawof financial success is to pay ones self first. No matter what, set aside a certain amount of current monthly income in an interest-bearing account and do not touch it until retirement. Take advantage of special programs such as 401(k)s, where employers matchcontributions you make up to a certain amount, essentially giving you free money for saving. Other options such as IRA (IndividualRetirement Accounts) allow you to invest income without paying taxes on it, reducing the cost of saving (e.g. if your tax bracket was25%, you could take $300 in net pay now, or invest $400 in your retirement account).

First Home or Last HomeRent or Buy?

A home remains the largest single investment most people make. The Internal Revenue Service permits homeowners to deduct fromtaxable income the interest payments annually made to their mortgage company. This deduction provides a large financialinducement for homeownership. It also helps support one of the largest sub-industry construction sectorsnew home buildinginthe US economy.

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In Sum

Think about your future before you act rashly today.


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y y y yYour income is based on your ability and education. Your financial ability to have a full life begins with a plan for the future. Control monthly expenses; keep the fixed costs of home and auto as low as possible. If possible, attend college and earn a degree, at least a certification. Loans and scholarships are available. The labor marketlikely will reward you.Prudently use credit cards, if at all. If you must, then strictly limit their use. Pay as much as possible toward the balance eachmonth. Never be content paying only the company prescribed minimum balance. Investigate large and non-routine purchases to make sure your income expectations likely will be met, before buying. Have a regular savings plan that earns compound interest. Let it grow without interruption.

Follow an investment plan. Diversify your investments. Spread your investment dollars across independent assets to achievea return that will meet your objective within your risk tolerance.Buying versus renting a home has lifestyle and economic motivations. Total price per square foot can be a useful guide.

o The tax deduction for mortgage interest is the largest single financial incentive for buying a home. o A good credit history qualifies one for the lowest current market interest rate.

Retirement needs to be prepared for.o Estimate expected income, medical coverage costs and keep fixed living expenses as low as possible. o Consider bartering for services instead of making outright purchases


Make legal and economic preparations for lifes final turn.


Lesson 11: Gross Domestic Product and Growth

National Income Measurement


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Prior to 1940 there was no consensus gauge by which to measure macroeconomic activity. That changed when Simon Kuznets of the US National Bureau of Economic Research devised the national income account structure and published his work in 1941,earning him the 1971 Nobel Prize in Economics. With only minor modifications, his schema survives to this day and most countrieson the planet use it. The summary measure of this national income structure was named Gross Domestic Product (GDP).

Gross Domestic Product Equivalent ViewsThe market value of all final goods produced within a country in 1 year, ORThe total income received by all producers (Supply View), OR

Total purchases of newly produced final goods (Demand View), ORThe sum of all transactions regarding final goods (Q = real output) soldat market value (P = average price level) = P Q

This national product measurement system with its interrelated income accounts rests on several key assumptions and, as with allmacro measures, suffers some limitations. The objective is to accurately and consistently account for all current economic activityand its major components over a stated period. By distinction, Gross National Product (GNP) is the total income earned by a nationspermanent residents, wherever they currently reside. For example, Toyota cars built in Texas are part of US GDP. Ford autos built inFrance are part of US GNP, but not US GDP.

Key assumptions behind the National Income and Product AccountsPrice changes during the period ignoredPopulation growth ignoredTechnology advances ignoredInvestment beyond asset replacement ignored

Limitations to Gross Domestic Product as a measure

Ignores product quality changesOmits household productionOmits sales of used goodsOmits in-kind and invisible transactionsExcludes illegal transactionsOmits financial transfers


A poor measure of psychological well-being


The important theoretical and practical questions are how and if the income paid to earners from the production process will be usedto collectively buy all the goods produced? This question is not trivial. For example, workers usually will not offer their labor servicesfor free. When all factors of production are paid for their effortfrom revenues the seller generates from sales to customersthe

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value of all income equals the value of all production. But will the act of supplying goods generate an equal demand to purchasethem in a reasonably short time period? If not, some current resources will be unemployed.

The table below shows the major components for US GDP, $14.1 trillion for 2009, from both the supply view and the demand view.Notice that GDP sums to the same figure for either view, except for a less than 1% error labeled statistical adjustment whichaccounts for the difficulty of reconciling the nations income and consumption reporting.

US Gross Domestic Product 2009 In Circular Flow Format*Income Categories or Supply Expenditure Categories or Demand

Business Hires and Pays $ for Factor InputsHouseholds supply Factor Inputs to Businesses

$ 11,114.4 Factor Income (F) Household Consumption(C) $ 10,001.3$ 1,861.1 Depreciation (D) Business Investment (I) $ 1,589.2$ 1,024.7 Indirect Business Taxes (T) Government Purchases (G) $ 2,914.9

(-)118.8 Statistical Adjustment Net Exports (NE) $ - 386.4

$14,119.0 Income Earned by Factor Resources = GDP GDP = Expenditures on Goods & Services $14,119.0

Businesses produce and sell goods and services to households Households Purchase Goods and Service from Businesses $

Source: www.bea.gov ; *Billions of US Dollars

To interpret the economic circular flows in the table above, the upper brown clockwise arrow represents the physical flow of labor andother inputs from households to businesses. The lower brown clockwise arrow represents the goods and services produced bybusiness using the factor inputs. The upper green counter clockwise arrow is the dollar income earned by households for supplyingfactor inputs (wages, interest and rent). The lower green counter clockwise arrow represents dollar expenditures for goods andservices purchased from businesses by households.



Th S l Vi f GDP
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The Supply View of GDP

From Factor Income to Household Consumption

Factor Income (F = $11,114.4 billion) is the total National Income paid by business for using all economic resources (land, labor,capital, entrepreneurship) as a cost of production. Factor costs to businesses are income payments to households. Households usetheir income, after paying income (direct) taxes, to consume or to save.

From Depreciation to Business Investment

Depreciation (D = $1,861.1 billion) accounts for the depletion of productive assets during the year. These are real costs in thesense that productive assets have limited useful lives and must be replaced when worn out.

From Direct and Indirect Taxes to Government Purchases

Indirect business taxes (T = $1,024.7 billion) are taxes levied on productive business enterprises and are a cost of doing business.Indirect business taxes transfer income from businesses to the government so it can make purchases.

Direct taxes are levied directly against an individuals income. Income taxes are a good example. Direct taxes are not a cost of doing business. These taxes, a percentage of each individuals personal income, generate flows moving directly from the incomeearner to the government so it can make purchases.

The Demand (Expenditure) View of GDP

Total economic activity (GDP = $14,119.0 billion) from the supply view must equal the sum of goods purchased by the four demand-side sectors. The largest demand-side sector, household consumption (C = $10,001.3 billion), measures purchases by the

households from the factor income paid to them, and accounts for nearly seventy percent of total demand for GDP.Next, government purchases of goods and services (G = $2,914.9 billion) provide public goods, market regulation, commonresource oversight and other public functions to account for 18 percent of GDP.



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Business cycle phases Expansion rising GDP and employment Recession falling GDP and rising unemployment Depression significantly falling GDP and rising unemployment Recovery rising GDP and employment after a recession

Separating time into two distinct periods helps. In the long run, a period of several years, an economy will tend to settle into whateconomists define as its natural rate of unemploymentthe rate around which unemployment fluctuates in a healthy economy. Inthis long period, changes in total economic demand affect only prices, not output, because the economy is producing along itsnatural growth path, about 3.5% annually for GDP in the US.

In the short run, a period of one to three years, much can change, and suddenly, from either the demand side or the supply side of the economy. When one sector of the economy shifts, the resulting chain of events can be described but not easily predicted in timesequence, since the underlying economic responses at work stem from all too human group behavior. Even for the 2008-2010recessionary cycle the pace and character of economic recovery were difficult to predict and to manage.



In Sum


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Gross Domestic Product (GDP) is the current dollar value of all final goods and services produced within a country in oneyear; and serves as the official measure of a nations economic activity.

o GDP measurement ignores: population growth, technology changes, investment above replacement and variances inindustry market structure.

o GDP is a rather narrow measure that ignores: product quality changes, household production, used good sales, in-kind transactions and illegal transactions.

The two views of GDP allow economists to measure and assess activity by the income earned by factors of production(supply) and the product purchased by economic sectors (demand).

o Supply view measures factor income in the form of rent, wages, interest and profit plus capital depreciation andindirect business taxes, the sum of which equals GDP.

o Demand view measures household consumption, government purchases, business investments and net exports, thesum of which equals GDP.

Demand = C + I + G + NE = F + T + D = Supply, is the basic macroeconomic relationship. In words, the total dollar value of goods supplied in the economy in one year equals the total amount of those goods demanded by the sum of householdconsumption, business investment, government purchases and net exports. Law of diminishing marginal returnsgiven fixed amounts of land and capital, as the quantity of labor input increases, totaloutput increases but at an eventually diminishing rate.Standard of livingA societys economic standard of living is measured by dividing total production for a year by totalpopulationProductivity measures and determinants of economic growth

o Quantity and quality of the labor forceo Quantity and quality of capital equipmento Level of work force educationo Technology

Business cyclefluctuations in economic activity caused by changes in business conditions affect income, production,employment, prices and interest rate

o Expansion rising GDP and employmento Recession falling GDP and rising Unemploymento Depression significantly falling GDP and rising Unemploymento Recovery rising GDP and employment after a recession



Lesson 12: Employment and Unemployment

Employment and Unemployment


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Work is essential to solving the economic problem for the individual and for society. Though the very young, the old, the infirm, theincarcerated and those in military service are excused from private market work, those in the workforce toil to produce the goodsconsumed by those groups, as well as for their own consumption. Human effort marks the beginning of the circular flow of economicactivity.

In a market-based society, sales of product fashioned through human application generate the earnings to sustain their collectivemakers. Those persons working are employed. Persons temporarily not working but seeking work are unemployed. Economistsfocus on the unemployed because their status reflects a loss of value to society and the affected individuals. Economists use

carefully-crafted definitions to measure and assess employment and unemployment.Labor force components

Total population all persons in the societyLess: persons under 16 years or institutionalized

Equals: the non-institutional populationo Less: those serving in the armed forces

Equals: the civilian non-institutional populationo Less: persons not in the labor force (neither working nor seeking work)

Equals: Civilian Labor Force (CLF) total number of workers over 16years of age who are either employed or unemployed.

o Employed persons in the labor force who have a fulltime or part time job.o Unemployed persons without a job who are actively seeking work and are available for work.o Unemployment Rate the number of unemployed persons divided by the labor force count.o Labor force participation rate the civilian labor force divided by the adult population 16 to 64 years old

US Labor Force DataYear Labor Force Employed Unemployed Rate

2009 153,172,000 137,960,000 15,212,000 9.9% 2010 153,690,000 139,206,000 14,484,000 9.4% Source: www.BLS.gov

http://www.bls.gov/http://www.bls.gov/http://www.bls.gov/


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frustration comes largely from lack of good information about the types, pay scale, location and availability of open positions.Economists recognize that while job search is costly, it is rarely due to a mismatch between supply and demand in the labor market.Rather, unemployed workers are busily searching for those jobs best suited to them.


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Economics of Minimum Wage Laws

US minimum wage laws become a topic for political debate each time the federal minimum wage is increased. The economic realityof minimum wage legislation is firmly established through many well-crafted studies. When the mandated minimum wage is setabove the market clearing wage ratethe unemployment rate for workers in minimum pay jobs rises.

In the chart above, you can see the two components of the increased unemployment from a higher minimum wage rate. Those jobs

where the value of work lies below the new minimum wage will be laid offthe demand-side market response. The markets supply-side reveals formerly discouraged job seekers, enticed by the new higher minimum wage, trying to re-join the labor force but unableto find work.


Workers in minimum wage positions who manage to keep their jobs do get higher pay. Though the higher minimum wage may or may not sustain a l

Economics for Educators Revised v 18G

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