PRINCIPLES OF

ECONOMICS:BUSINESS, BANKING, FINANCE,

AND YOUR EVERYDAY LIFE

COURSE GUIDE

Professor Peter NavarroUNIVERSITY OF CALIFORNIA, IRVINEPAUL MERAGE SCHOOL OF BUSINESS

Principles of Economics:Business, Banking, Finance, and

Your Everyday Life

Professor Peter NavarroUniversity of California, IrvinePaul Merage School of Business

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Principles of Economics:Business, Banking, Finance, and Your Everyday Life

Professor Peter Navarro

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Course Syllabus

Principles of Economics:Business, Banking, Finance, and Your Everyday Life

About Your Professor ......................................................................................................4

Introduction ......................................................................................................................5

Lecture 1 Introduction to Macro- and Microeconomics............................................6

Lecture 2 The Business Cycle and the Warring Schoolsof Macroeconomics ..................................................................................8

Lecture 3 Fiscal Policy and Budget Deficits: The Good, Bad, and Ugly................14

Lecture 4 Monetary Policy: It’s All About Money, Credit, and Banking..................22

Lecture 5 Unemployment and Inflation: Enter the Dragons...................................28

Lecture 6 International Trade and Protectionism: Where DidOur Jobs Go?.........................................................................................34

Lecture 7 The International Monetary System, Exchange Rates,and Trade Deficits ..................................................................................40

Lecture 8 Supply, Demand, and Equilibrium: How Prices Are Setin Our Markets........................................................................................45

Lecture 9 Understanding Consumer Behavior: The Essential Elements...............49

Lecture 10 Producer Behavior and an Introduction to Perfect Competition ............54

Lecture 11 Market Structure, Conduct, and Performance: WhyMonopolists Do What They Do ..............................................................61

Lecture 12 Why the Government Intervenes in Our Markets andLives: The Economist’s Critique.............................................................66

Lecture 13 Government Taxation from the Cradle to the Grave:The Big Issues .......................................................................................70

Lecture 14 Land, Labor, and Capital: How Our Rents, Wages, andInterest Rates Are Set............................................................................76

Course Materials............................................................................................................80

Peter Navarro is a business professor at thePaul Merage School of Business at theUniversity of California, Irvine. He holds aPh.D. in economics from Harvard Universityand is the author of the best-selling invest-ment book If It’s Raining in Brazil, BuyStarbucks. His latest book is The Well-TimedStrategy: Managing the Business Cycle forCompetitive Advantage, which illustrates howa knowledge of macroeconomics can beused to improve executive decision-making.

Professor Navarro’s articles have appeared in a wide range of publications,from the Harvard Business Review, Sloan Management Review, and WallStreet Journal to the Los Angeles Times, New York Times, and WashingtonPost. He has made frequent guest appearances on major financial news sta-tions, including Bloomberg Television, CNBC, and CNN.

Professor Navarro’s weekly stock market newsletter, the Big PictureInvestor, is distributed to several thousand readers and available free ofcharge at www.peternavarro.com.

You will get the most out of this course if you have the following book:

Economics: Principles, Problems, and Policies, 16th edition, by Campbell R.McConnell and Stanley L. Brue (New York: McGraw-Hill, 2005).

You will find it useful for the lectures on macroeconomics to also have acopy of If It’s Raining in Brazil, Buy Starbucks, New York: McGraw-Hill, 2004,which provides an excellent overview of the various economic indicators usedto forecast the business cycle. It also illustrates how to use macroeconomicsin a stock market investing context.

Acknowledgment

My deep thanks to Pedro Sottile for his yeoman work as my long-timeresearch associate. I’d also like to profusely thank my technical “whiz kid”Richard Stanley for his wonderful sound editing work in the early stages ofrecording this project.

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©PhotocourtesyofProfessorPeterNavarro

About Your Professor

Peter Navarro

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IntroductionThis course introduces both macroeconomics and microeconomics.Macroeconomics focuses on the big economic picture—specifically, how theoverall national and global economies perform. It is a subject that focuses onbig problems like unemployment and inflation and the dire threats that largebudget deficits and trade deficits can pose for economic well-being.

At a business and professional level, macroeconomics can help to answerquestions such as the following: How much should I manufacture this month?How much inventory should I maintain? Should I invest in new plant andequipment? Expand into foreign markets? Or downsize my firm?

At a personal level, macroeconomics can also help to answer equally impor-tant questions: Should I switch jobs—or ask for a raise? Should I buy ahouse now or wait until next year? Should I get a variable or fixed-rate mort-gage? And what about my investments for retirement?

In contrast, microeconomics deals with the behavior of individual marketsand the businesses, consumers, investors, and workers who make up themacroeconomy. Microeconomics focuses on issues such as how prices areset, how wages are determined, how rents are set, and why the governmentis sometimes forced to regulate industries that are too monopolistic, that pol-lute too much, or that may conceal vital information.

At a business level, microeconomics can help to answer the following ques-tions: How can my firm minimize its costs and increase its profits? Whatprices should I charge for my products? How should I respond to an aggres-sive strategic move by one of my competitors?

At a personal level, microeconomics is equally practical. It can help toanswer questions such as the following: Will I really be better off financially ifI quit my job now and go back for an MBA degree? What kind of careershould I be preparing myself for? What about that new refrigerator or automo-bile I want to buy—should I get the new, energy-efficient one with the higherprice tag or settle for the cheaper model?

Most broadly, microeconomics can help you to understand why the govern-ment is so involved in our economic lives. It can do so by answering ques-tions such as the following: Why does the government regulate prices inindustries like electricity and gas, but not in others? Why are there lawsrequiring seat belts and motorcycle helmets? Why do we have a FederalEnvironmental Protection Agency and thousands of rules about workplacesafety? And why does the government provide some goods and let the freemarket provide others?

My hope is that you will not only enjoy this course immensely, but you willalso find it helpful in those areas of economics that affect both your personaland professional life.

Good luck!

~Peter Navarro

www.peternavarro.com

Introduction toMacroeconomics andMicroeconomics

• Economics can bea difficult subjectat times, but it isalso one of themost interestingand readilyapplicable sub-jects that you canever learn.

• We distinguish between the two main branches of economics: macroeco-nomics and microeconomics.

• Macroeconomics is a subjectthat focuses on big problemslike unemployment and infla-tion and the dire threats thatlarge budget deficits andtrade deficits can pose forour economic well-being.

• Microeconomics deals withthe behavior of individualmarkets and the businesses,consumers, investors, andworkers that make up themacro economy.

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Lecture 1:Introduction to Macro- and Microeconomics

LECTURE OBJECTIVES

1. Introduce some of the big problems in macroeconomicsand microeconomics.

2. Illustrate quite specifically how macroeconomics and microeco-nomics affect you in your personal and professional life.

3. Show how to incorporate an understanding of economics intoyour daily decision making.

4. Outline the course and its contents.

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1. Why do we call economics the dismal science?

2. Which branch of economics is more important—macroeconomicsor microeconomics?

3. What kind of questions can macroeconomics help you to answer from apersonal and professional perspective?

1. Website for the National Bureau of Economic Research — www.nber.org

2. Information on macroeconomics events and studies — www.dismal.com

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Websites to Visit

Questions

The BusinessCycle

(See Figure 2.1)

1. All movementsin the businesscycle are mea-sured by therate of growth ofthe real grossdomestic prod-uct (GDP). Anation’s nominalGDP measuresits economic output; the real GDP is the nominal GDP adjustedfor inflation.

2. The movements of the GDP define the business cycle, which charts therecurrent moves from an expansionary phase and some inevitable “peak”when business activity reaches a maximum, to a recessionary phase andsome inevitable “trough” brought on by a downturn in total output, to a“recovery” or upturn in which the economy expands toward full employ-ment. Note that each of these phases of the cycle oscillates around a“growth trend” line.

3. There are three main explanations for business-cycle volatility.

4. The first explanation for business-cycle volatility centers on random,external shocks to the economic system. These so-called “exogenousshocks” include both negative, recession-inducing events as well as posi-tive, expansionary-enhancing “productivity shocks.”

5. In the second explanation, the economy is typically viewed as inherentlystable. Yet it can be thrown off course by policy errors and miscalcula-

Lecture 2:The Business Cycle and the

Warring Schools of Macroeconomics

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1. Learn about the business cycle and how its movements fromrecession to expansion and back to recession are measured.

2. Explore the reasons why recessions and expansions happen inthe business cycle.

3. Explore the so-called “warring schools” of macroeconomics andexamine their very different views of why the economy may suf-fer problems and what should be done to solve those problems.

4. Show how these warring schools relate to very real political fig-ures that have shaped our lives.

LECTURE OBJECTIVES

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tions or, in the worst case, by Machiavellian politicians using the powersof incumbency to enhance their re-election fortunes.

6. The third major explanation of business-cycle movements relies on amuch more complex and systemic view of the economy. It is character-ized by the “co-movements” of many variables.

7. The task for macroeconomists trying to use fiscal and monetary policiesto better manage the business cycle is to understand this process in allits richness.

Warring Schools of Macroeconomics:

1. The five major warring schools range from classical economics andKeynesianism to monetarism, supply-side economics, and newclassical economics.

Classical Economics

2. History begins with classical economics, which dates back to the late1700s. The classical economists believed that the problems of recessionand unemployment were a natural part of the business cycle, that theseproblems were self-correcting, and, most importantly, that there was noneed for the government to intervene in the free market to correct them.

3. This approach actually seemed to work—until the Great Depression ofthe 1930s.

Figure 2.1The Business Cycle

© Peter Navarro

Keynesianism

4. British economist John Maynard Keynes flatly rejected the classicalnotion of a self-correcting economy. Instead, Keynes believed that theglobal economy would not naturally rebound but simply stagnate or,even worse, fall into a death spiral. In his view, the only way to get theeconomy moving again was to prime the economic pump with increasedgovernment expenditures.

• In the United States, Franklin Delano Roosevelt’s Keynesian “NewDeal” public works programs in the 1930s, together with the 1940sKeynesian boom of World War II expenditures, lifted the Americaneconomy out of the Great Depression and up to unparalleled heights—just as Keynes predicted.

• Pure Keynesianism reached its zenith with the much-heralded KennedyTax Cut of 1964, which would make the 1960s one of the most prosper-ous decades in America as business boomed.

5. The aggressive fiscal stimulus after World War II laid the foundation forthe emergence of a new macroeconomic problem that Keynesian eco-nomics would be totally incapable of solving: “stagflation”—simultaneoushigh inflation and high unemployment.

6. The Keynesian dilemma was that using expansionary policies to reduceunemployment simply created more inflation, while using contractionarypolicies to curb inflation only deepened the recession.

The stagflation problem had it roots in President Lyndon Johnson’sstubbornness. In the late 1960s, Johnson increased expenditures onthe Vietnam War but refused to cut spending on his Great Society socialwelfare programs.

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Line at a Soup Kitchen

In February 1931,unemployed men linedup outside a soup kitchenopened in Chicago byAl Capone.

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Monetarism & Supply-side Economics

7. Professor Milton Friedman’s monetarists challenged what had becomethe Keynesian orthodoxy. Friedman argued that the problems of bothinflation and recession may be traced to one thing—the rate of growth ofthe money supply. From this monetarist perspective, stagflation is theinevitable result of activist fiscal and monetary policies that try to pushthe economy beyond its so-called “natural rate” of unemployment—defined as the lowest level of unemployment that can be attained withoutupward pressure on inflation.

8. The conservative school of supply-side economics entered the stageafter the monetarist’s bitter medicine to correct stagflation. Specifically,supply-siders believed that people would actually work much harder andinvest much more if they were allowed to keep more of the fruits of theirlabor. In such a scenario, the supply-siders promised that by cuttingtaxes and thereby spurring rapid growth, the loss in tax revenues from atax cut would be more than offset by the increase in tax revenues fromincreased economic growth.

• In the 1980 U.S. presidential election, Ronald Reagan ran on a supply-side platform that promised to simultaneously cut taxes, increase gov-ernment tax revenues, and accelerate the rate of economic growthwithout inducing inflation. Unfortunately, that didn’t happen: while theeconomy boomed, so too did America’s budget and trade deficit.

• In the Bush White House, Ronald Reagan’s supply-side advisors hadbeen supplanted not by Keynesians, but rather by a new breed ofmacroeconomic thinkers—the so-called “new classicals.”

New Classical Economics

9. The new classical school is rooted in the classical economic tradition.New classical economics is based on the controversial theory of rationalexpectations, which maintains that if you form your expectations “rational-ly,” you will take into account all available information. The idea behindrational expectations is that activist fiscal and monetary policies might beable to fool people for a while; however, after a while, people will learnfrom their experiences, and then you can’t fool them at all. The centralpolicy implication of this idea is, of course, profound: rational expecta-tions render activist fiscal and monetary policies completely ineffective,so they should be abandoned.

10. Economically, critics of rational expectations say that most people arenot as sophisticated in their economic thinking as the theory requires,and therefore adjustments will not take place with anywhere near thespeed they are supposed to.

11. However, this criticism should not detract from the central point of rationalexpectations, namely, that people’s behavior may partially, or perhapscompletely, counteract the goals of activist fiscal and monetary policies.

It is important not just because of the strong influence it has had onrecent macroeconomic theory but also because new classical econo-mists played a pivotal role during the 1992 defeat of the first GeorgeBush by Bill Clinton. Bush took the new classical advice, the economylimped into the 1992 presidential election, and, like Richard Nixon in1960, Bush lost to a Democrat promising to get the economy movingagain. The irony, of course, is that Bush’s fiscally conservative new clas-sical response set the stage for the Clinton boom—the longest expan-sion in U.S. history.

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The Warring Schools of Macroeconomics

Mainstreammacroeconomics Rational Supply-side

Issue (Keynesian based) Monetarism expectations economics

View of the Potentially unstable Stable in long run Stable in long run May stagnateprivate economy at natural rate of at natural rate of without proper

unemployment unemployment work, saving,and investmentincentives

Cause of the Investment plans Inappropriate Unanticipated AD Changes in ASobserved insta- unequal to saving monetary policy and AS shocks inbility of the plans the short tunprivate economy

Appropriate Active fiscal and Monetary rule Monetary rule Policies tomacro policies monetary policy increase AS

How changes in By changing the By directly No effect on By influencingthe money supply interest rate, which changing AD, output because investment andaffect the changes invest- which changes price-level changes thus ASeconomy ment and real GDP GDP are anticipated

View of the Unstable Stable No consensus No consensusvelocity of money

How fiscal policy Changes AD No effect unless No effect on output, Affects GDP andaffects the via the multiplier money supply because price- price level viaeconomy process changes level changes changes in AS

are anticipated

View of cost-push Possible (wage- Impossible in the Impossible in the Possible (tax-inflation push, AS shock) long run in the long run in the transfer dis-

absence of absence of incentives, higherexcessive money excessive money costs due tosupply growth supply growth regulation)

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1. What is the difference between nominal GDP and real GDP?

2. State the phases of the business cycle.

3. Who determines whether the economy is in a recession or an expansion?

4. What are the five warring schools of macroeconomics?

5. Which of the warring schools of economics is the best school to follow?

6. On what issues do the warring schools of macroeconomics converge?

7. Explain the Keynesian view of the Great Depression.

8. For the Monetarists, why does the endorsement of a monetary rule makethe most sense?

9. Explain the new classical view of a self-correcting economy.

10. Why do the supply-side tax cuts differ from those of the Keynesians?

11. Were the tax cuts implemented by George W. Bush in the United StatesKeynesian tax cuts or supply-side tax cuts?

1. Choose the appropriate link to review the history of the U.S. businesscycle; pinpoint where the business cycle might be currently —www.nber.org

2. The History of Economic Thought website is the most detailed websiteabout schools of economic theory; select “Schools of Thought” and learnmore about schools of macroeconomics not covered in this lecture —http://cepa.newschool.edu/het

3. Go to the Catalogue Resources tab and select “Schools of EconomicThought” from the Detailed Search option; the site contains summaries andlinks devoted to many economists and schools of economic theory —www.econport.org

McConnell, Campbell R., and Stanley L. Brue. Chapter 19. Economics:Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.

Navarro, Peter. Introduction, and Chapters 1 and 12. If It’s Raining in Brazil,Buy Starbucks. New York: McGraw-Hill, 2001.

Snowdon, Brian, Howard Vane, and Peter Wynarczyk. A Modern Guide toMacroeconomics: An Introduction to Competing Schools of Thought.Cheltenham, UK: Edward Elgar Publishers, 1995.

Websites to Visit

Questions

Suggested Reading

FOR GREATER UNDERSTANDING

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Fiscal Policy:Historical Perspective

1. In October 1929, the U.S. stockmarket crashed and sent thebusiness community into a panic.Reacting to the crash, businessescut back sharply on investmentand production. At the same time,frightened consumers cut backdramatically on consumption—while attempting to save more asa response to the crisis.

2. The irony is that in their attemptto save more, many individualhouseholds actually saved lessbecause their incomes plummet-ed as the economy weakened.This result is known as the “para-dox of thrift,” and it can be animportant contributor to reces-sionary events.

3. Because of this depressed consumption and investment and ever-expanding layoffs, the economy continued its downward spiral. Event-ually, unemployment reached a staggering 25 percent of the workforce.

4. For President Herbert Hoover, a follower of the classical school of eco-nomics, the answer was to wait. Eventually, prices would fall and peoplewould start buying more, wages would fall and businesses would starthiring again, and, through this so-called “price adjustment mechanism,”the economy would bounce right back—or, as Hoover himself put it,“prosperity is just around the corner.”

5. Contrary to this view, and as the U.S. economy and economies aroundthe world sunk further into this Depressionary morass, British economist

1. Illustrate the basic Keynesian model and show how the applica-tion of the model gave birth to fiscal policy.

2. Learn about fiscal policy, which involves the use of governmentexpenditures or tax changes to expand or contract an economy.

3. Understand why fiscal policy is one of the most potent tools thatgovernments have to stimulate or contract an economy.

Lecture 3:Fiscal Policy and Budget Deficits:

The Good, Bad, and Ugly

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Panicked investors on Wall Street, October 24, 1929.

LECTURE OBJECTIVES

Lord John Maynard Keynes and his so-called “income adjustment mechanism”showed that when an economy sinksinto a recession, people’s incomes fall.This fall in income causes them tospend less and save less while busi-nesses respond by investing and pro-ducing less. This reduction in con-sumption, savings, investment, andoutput, in turn, drives the economydeeper into recession rather than backto full employment.

6. In this scenario, Keynes believed thatthe only way out of a severe depres-sion was to “prime the economicpump” with increased governmentspending. This was precisely the ideabehind fiscal policy.

7. Once Herbert Hoover was replaced byFranklin Delano Roosevelt, the government did indeed start to spend—first on FDR’s so-called New Deal public works projects and then farmore dramatically on defense expenditures for World War II. Together,these twin stimuli triggered increased consumption and investment, andthe economy roared back to full employment.

Basic Keynesian Model

1. The most important assumption underlying the basic Keynesian model isthat prices are fixed. Keynes himself didn’t believe this, of course. ButKeynes did believe that when the economy is in the recessionary range,prices and wages are sufficiently inflexible so that income would adjustmuch faster than prices.

2. One of the important insights of this Keynesian model relates to the con-cepts of leakages and injections.

3. In this Keynesian model, the economy will be in equilibrium at a pointwhere aggregate expenditures are equal to aggregate production.However, if, at that point, the economy is not producing at full capacity,there is a so-called “recessionary gap” that must be filled by increasedgovernment spending or some other stimulus to demand like a tax cut.(See Figure 3.1)

4. In the famous Keynesian equation, “aggregate expenditures” equal con-sumption plus investment plus government expenditures plus net exports.

5. The most important thing to understand about aggregate expenditures inthe Keynesian model is that people don’t spend every dollar they earn.Rather, they have a so-called marginal propensity to consume (MPC),which measures the fraction of every additional dollar that a personwill spend.

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Herbert Hoover

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Consumption

1. The largest component of aggregate expenditures is consumption,accounting for almost 70 percent of total aggregate expenditures in theU.S. economy. Consumption occurs in three categories: durable goods,non-durable goods, and services.

2. Keynes explained consumption expenditures by defining two distinctcomponents: autonomous and induced consumption.

3. First, Keynes posited that there is a level of consumption called“autonomous consumption” that will occur even if a person’s income fallsto zero, regardless of changes in one’s income.

4. Second, Keynes said that there is a level of “induced consumption”that depends on the individual’s disposable income, where disposableincome is simply the amount of money you have left after paying taxesto the government.

5. Keynes further described this consumption behavior in terms of a per-son’s MPC, which is simply the extra amount that people consume whenthey receive an extra dollar of disposable income.

Example: some people may only spend seventy-five cents of every dollarof their disposable income and save twenty-five cents. In this case, theMPC is 3/4.

Investment

1. Investment expenditures include the purchases of homes, investment inbusiness plant and equipment, and additions to a company’s inventory.

Figure 3.1The Keynesian Model© Peter Navarro

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Investment in plant and equipment is by far the biggest category,averaging a full 70 percent of total investment annually, while totalinvestment expenditures account for roughly 15 percent of totalaggregate expenditures.

2. In the Keynesian model, investment expenditures are assumed to occurindependently of the level of income.

3. To Keynes, the two important determinants of investments are the sensi-tivity of investment to changes in the interest rate and the “expectations,”or business confidence, that businesses have regarding potential salesand profits.

4. Note, however, that while Keynes believed the interest rate was impor-tant in determining investment, he did not believe that falling interestrates and increased investment would necessarily lead to a full-employ-ment equilibrium like the classical economists did. This is becauseKeynes believed that investment was in large part driven by the expecta-tions that businesses had regarding potential sales and profits. Keynesreferred to these expectations as “animal spirits” and basically said that ifbusinesses believed the economy was about to go bad, it could becomea self-fulfilling prophecy.

Government Spending

1. Government spending includes purchases of goods like tanks or road-building equipment as well as the services of judges and public schoolteachers. Such government expenditures account for almost 20 percentof total aggregate expenditures in the United States.

2. In the Keynesian model, increased or decreased government expendi-tures, together with tax cuts or tax increases, serve as the primary toolsof fiscal policy that are used to counterbalance changes in investmentand consumption spending.

3. Specifically, expansionary fiscal policy involves increased govern-ment expenditures, tax cuts, or some combination of the two tostimulate a recessionary economy and close a recessionary gap. In con-trast, contractionary fiscal policy involves reduced government expendi-tures, tax hikes, or some combination of the two to cool down an over-heated economy.

Net Exports

1. Net exports equals the value ofexports minus the value of imports.Exports create domestic production,income, and employment foran economy, so we addexports to aggregateexpenditures. However,when we purchaseimports from a foreigncountry, no such produc-

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tion, income, or employment is created,so imports must be subtracted fromaggregate expenditures.

2. While net exports are an important part ofa global, or “open,” economy, they werenot central to the development of theKeynesian multiplier model. Therefore, weassume a “closed economy” in whichthere is no international trade and dropnet exports from the model.

Keynesian Multipliers

1. The Keynesian expenditure multiplier is the number by which a change inaggregate expenditures must be multiplied to determine the resultingchange in total output. This multiplier is always greater than one.

2. In the Keynesian model, it can be shown mathematically that theKeynesian multiplier is simply the reciprocal of one minus the MPC.Hence, the higher the MPC, the bigger the multiplier.

Example: Suppose that the MPC is 0.5. Then the multiplier is 2, or 1divided by 1 minus 0.5. If the MPC is 0.75, the multiplier is 4, or 1 dividedby 1 minus 0.75.

3. The Keynesian tax multiplier is simply the regular expenditure multipliertimes the MPC.

Expansionary Fiscal Policy: Numerical Example

1. Let’s assume thatthe full employ-ment output of theeconomy is $900billion, but theeconomy is stuckat a recessionaryoutput of $800 bil-lion. In otherwords, we’ve got arecessionary gapof $100 billion tofill so that peoplewon’t be out ofwork—as illustrat-ed in Figure 3.2.

2. If the marginalpropensity to con-sume is 0.8, we

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Figure 3.2A Recessionary Gap

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calculate a multiplier of 5. So if the government wants to close that $100billion recessionary gap, all it needs to do is increase spending by $20billion dollars—because an expenditure multiplier of 5 times the $20 bil-lion dollar spending hike equals $100 billion.

3. Alternatively, let’s suppose we prefer to cut taxes. In our example, itmeans we don’t cut taxes by $20 billion dollars, but by $25 billion dol-lars—or $5 billion more than we needed to increase government expen-ditures to achieve the same result. We arrive at this total by first multi-plying the expenditure multiplier of 5 times the MPC, yielding a tax multi-plier of 4. Then, 4 times the $25 billion tax cut yields the desired $100billion expansion.

4. The reason for the difference is that a dollar’s worth of tax cuts actuallyhas slightly less of an expansionary effect than a dollar’s increase in gov-ernment expenditures. With a tax cut, consumers will not increase theirexpenditures by the full amount of the tax cut. Instead, they will save aportion of that tax cut based on their marginal propensity to consume.

Contractionary Fiscal Policy: Example

To close an inflationary gap, we can cut government expenditures,raise taxes, or use a combination of the two fiscal policies to coolinflationary pressures.

Budget Deficits

1. Indeed, there are many problems with this mechanistic Keynesian view;and there may be no problem bigger than the budget deficits that expan-sionary fiscal policies can give rise to.

2. In thinking about problems associated with chronic budget deficits and asoaring national debt, economists establish a benchmark by comparingthe debt to the size of the nation’s GDP. Accordingly, comparing the debtto the GDP gives us a measure of a nation’s ability to produce and there-fore its ability to pay off its debt.

Even though the United States has the largest public debt in absoluteterms, on a debt-to-GDP basis, it doesn’t fare anywhere nearly as badlyas many other nations.

3. One crucial feature that is concerned with the problem of chronic budgetdeficits is related tothe distinction betweenthe so-called structuraldeficit and thecyclical deficit.

4. The structural deficit isthat part of the actualbudget deficit thatwould exist even if theeconomy were at fullemployment. Thestructural part of the

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budget is thought of as “active” and is determined by discretionaryfiscal policies.

5. In contrast, the cyclical deficit is that part of the actual budget deficitattributable to a recessionary economy. It results primarily from theshortfall of tax revenues that arises when the economy’s resourcesare underutilized.

6. The distinction is important because it helps policymakers distinguishbetween long-term changes in the budget caused by discretionary poli-cies versus short run changes caused by the business cycle.

Budget Deficit Financing

1. We have to recognize that the kind of problems the deficit and debt maycause is in large part determined by how the deficit is financed. In theory,there are three major ways the government can finance a deficit: raisingtaxes, borrowing money, or printing money.

2. In practice, however, raising taxes is politically unpopular. This meansthat the government has to resort to one of two other means to financethe deficit: borrowing money or printing money.

3. With the “Borrow Money” option, the U.S. Treasury sells IOUs in the formof bonds or Treasury bills directly to the private capital markets and usesthe proceeds of the sales to finance the deficit. In this case, the FederalReserve is out of the loop.

4. Note that the U.S. Treasury is competing directly in the capital marketswith private corporations, which may also be seeking to sell bonds andstocks in order to raise capital to invest in new plant and equipment. Inorder to compete for these scarce investment dollars, the Treasury typi-cally must raise the interest rate it is offering in order to attract enoughfunds. In this case, deficit spending by the government is said to “crowdout” private investment.

5. The crowding out effect is one of the most important concepts in macro-economics, because it places clear and obvious limits on the use ofexpansionary fiscal policies to stimulate an economy.

6. At least in theory, it’s possible to avoid crowding out altogether with the“Print Money” option. With this option, the Federal Reserve is said to“accommodate” the Treasury’s expansionary fiscal policy.

7. In particular, the Fed simply buys the Treasury’s securities itself ratherthan letting these securities be sold in the open capital markets. To payfor these deficit-financing Treasury securities, the Federal Reserve simplyprints new money.

8. The problem with this option is that the increase in the money supply cancause inflation—an undesirable result in and of itself. Moreover, if suchinflation drives interest rates up and private investment down—as it islikely to do—the end result of the Print Money option may be a crowdingout effect as well.

1. What is the most important assumption underlying the Keynesian model?

2. What are the aggregate expenditures?

3. State the difference between autonomous consumption and induced con-sumption in the Keynesian model.

4. Define the Keynesian expenditure multiplier. How is it calculated?

5. Who sets the fiscal policy?

6. Is it more favored to increase government spending or cut taxes to elimi-nate recessionary gaps?

7. What is the difference between structural and cyclical budget deficits?

8. Explain the “crowding out” effect.

1. Democrats usually recommend increasing government spending duringrecessions and raising taxes to fight demand-pull inflation. Republicansgenerally favor tax cuts during recessions and cuts in government spend-ing to fight demand-pull inflation. To learn more about fiscal policy, checkout these websites:

The Progressive Policy Institute — www.ppionline.org(go to the “Economic and Fiscal Policy” link)

The Cato Institute — www.cato.org(go to “Research Areas” and click on “Budget and Taxes”)

2. Choose “Browse the FY Budget,” then select “Historical Tables” andcheck “Federal Debt” to get a grasp of the historical evolution of the U.S.public debt in terms of its level, as a percentage of the GDP, and by hold-ers — www.gpo.gov/usbudget

3. Website of the Bureau of the Public Department–U.S. Department of theTreasury; use the site to identify the different kinds of U.S. Treasury secu-rities being offered on a regular basis by the Treasury to finance part ofthe government expenditures — www.publicdebt.treas.gov

McConnell, Campbell R., and Stanley L. Brue. Chapters 9, 10, and 12.Economics: Principles, Problems, and Policies. 16th ed. New York:McGraw-Hill, 2005.

Navarro, Peter. Chapters 13, 16, and 17. If It’s Raining in Brazil, BuyStarbucks. New York: McGraw-Hill, 2001.

The Wall Street Journal editorial page provides insight into the conservativeapproach to fiscal policy.

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Websites to Visit

Questions

Suggested Reading

Money and Its Functions

1. Money has a broad definition. It is anything that can be widely used andaccepted in exchange for other goods and services. In practice, there arethree kinds of money: commodity money such as gold or silver; bankmoney such as a checkbook; and paper or fiat money such as dollar bills.

2. An important observation to make about money is that it is the most “liq-uid” of assets, meaning that it is the most readily spendable.

3. Money has three major functions. First, money is a medium of exchange.Second, money serves as a unit of account or standard of value. Third,money serves as a store of value. However, it is the last function thatmoney performs least well: in the presence of inflation, money can rapidlylose its value.

1. Describe our money and banking system and explain how theFederal Reserve, the nation’s central bank, creates money.

2. Show how the Federal Reserve conducts active monetary policy.

3. Compare the Keynesian vs. Monetarist approach to active mone-tary policy.

Lecture 4:Monetary Policy: It’s All AboutMoney, Credit, and Banking

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The Interest Rate

1. When we examine how money affects economic activity, we focus on theimpact of the interest rate.

2. Technically, the interest rate is the amount of interest paid per unit oftime expressed as a percentage of the amount borrowed.

3. Interest is the payment made for the use of money, and it is often calledthe “price of money.” Note that there is actually a vast array of interestrates—short-term rates and long-term rates, government bond rates andcorporate bond rates, and so on—not just “the” interest rate.

4. There are three main reasons why interest rates differ across time andthe types of interest-bearing assets: the term or maturity of the loan, thedegree of risk, and liquidity.

The Demand for Money

1. The two major determinants of money demand are known as the transac-tions demand and the asset demand.

2. The transactions demand for money arises because people and firmsuse it as a medium of exchange.

3. In contrast, the asset demand or speculative motive for holding moneyarises because people use money as a store of value.

4. Note that while money is an asset, money provides no rate of return orinterest like other assets. Moreover, if either the interest rate or theexpectation of inflation increases, there is an increasing “opportunity cost”of holding money that includes the interest or rate of return that couldhave been earned by lending or investing the money as well as the lossin value from holding money during inflation. Therefore, the assetdemand for money must decrease.

The Early Goldsmiths

1. The goldsmiths emerged as thefirst commercial bankers. Today’smodern banks function much likethe goldsmith system.

2. In this earlier era, people askedtheir goldsmiths to store the goldthey didn’t want to carry withthem. The goldsmiths, in turn,would give the gold depositors apaper receipt and when a depos-itor needed to get some gold tomake a purchase, he or shewould use that receipt to redeemthe gold.

Goldsmith’s Workshopby the School of Agnolo Bronzino,

Florence, sixteenth century © Clipart.com

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3. Three important things happened with these goldsmiths.

4. First, the depositors figured out they could trade their gold receipts forgoods. These receipts functioned, in effect, as the first paper money.

5. Second, the gold depositors soon figured out that they didn’t have toleave their gold with the goldsmith for free. Goldsmiths began to offerdepositors interest on their gold deposits.

6. Finally, the goldsmiths figured out that they could operate under what istoday called a system of “fractional reserves.” Such a system allowed thegoldsmiths to expand the supply of money over and above the amount ofgold reserves they held in their vaults.

About the Federal Reserve and the Modern Banking System

1. Created in 1913, the Federal Reserve, or “The Fed,” is the nation’scentral bank. Through its control of bank reserves, the Fed sets the levelof short-term interest rates and has a major impact on outputand employment.

2. From a global perspective, the Fed is a somewhat peculiar central bank: itis both decentralized and privately owned. It consists of twelve regionalbanks spread across the country, and they are owned by the commercialbanks. While legally these twelve regional banks are private, in reality, theFed as a whole behaves as an independent government agency.

3. Its board of governors comprises seven members nominated by the pres-ident and confirmed by the Senate to serve overlapping terms of fourteenyears; members of the board are usually bankers or economists.

4. The key policy-making body at the Fed is the Federal Open MarketCommittee. This committee consists of twelve people: the seven mem-bers of the Fed’s board of governors plus the president of the New YorkFederal Reserve District Bank plus four rotating members from the othereleven Federal Reserve District Banks.

5. At the pinnacle of the system is the chairman of the board of governors.Often called the “second most powerful individual in America,” he acts aspublic spokesperson for the Fed and exercises enormous power overmonetary policy.

Fed Functions and the Monetary Policy

1. The Fed can serve as the “lender of last resort,” so that if a bank needsmoney to pay off its depositors, it can always borrow it from the Fed,which is, in essence, a “banker’s bank.” That may take place when abank run occurs—when too many of the bank’s depositors demand theirmoney at the same time.

2. Besides issuing currency and being the lender of last resort, the Fedhas four other functions, including regulating our financial institutions,providing banking services to the federal government, providing financialservices to the nation’s banks, and, most importantly, conducting mone-tary policy.

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3. In particular, monetary policy involves the use of changes in the moneysupply to contract or expand the economy.

4. The Fed manages monetary policy through its Federal Open MarketCommittee. The Open Market Committee meets periodically to discussmonetary policy, and it conducts such monetary policy through the use ofthree major policy instruments.

5. The first, and least used, of these instruments is setting the reserve ratioor the reserve requirement. The Fed can increase the money supply bylowering the reserve requirement or decrease the money supply by rais-ing the reserve requirement.

A related concept is that of the money-supply multiplier, which is simplyone divided by the bank’s required reserve ratio. Note that the bigger thereserve requirement, the smaller the money multiplier and the lessmoney that is created by a new dollar of demand deposits.

6. The second instrument of monetary policy is the discount rate. The dis-count rate is the interest rate that the Fed charges banks when they bor-row money from the Fed. Lowering the rate makes it cheaper for banksto borrow money and expand the money supply. In contrast, raising thediscount rate makes it more expensive for banks to borrow from the Fedand is contractionary.

7. The third, and by far the most important, instrument of monetary policy isopen market operations. Open market operations involve the buying andselling of government securities to expand or contract the money supply.In a nutshell, the Fed buys government securities when it wants toexpand the money supply, and it sells government securities when itwants to contract the money supply. (See Figure 4.1)

Figure 4.1: Open Market Operations

© Peter Navarro

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The Monetary Transmission Mechanism

1. The so-called monetary transmission mechanism refers to the interven-tion of the Fed and its consequent effect on the aggregate demand.

2. The process begins with the change on reserves through open marketoperations and the resulting change in money supply and interest rates.In the next step, the change in interest rates modifies the level of invest-ment and consumption expenditures. The total effect is to change aggre-gate expenditures or aggregate demand. Therefore, real GDP and infla-tion likewise move, thus achieving the desired policy goal of stimulatingor cooling the economy and inflationary pressures.

Keynesianism vs. Monetarism

1. From a purely mechanistic Keynesian point of view, monetary policy isconducted with less precision than fiscal policy. In the case of monetarypolicy, Keynesians argue that the link between the money supply andshifts in the aggregate expenditure curve is much more complex, relyingon changes in the interest rate and the response of investment, con-sumption, and net exports.

2. In defining an activist role for monetary policy, Keynesians believe thatmonetary policy is most effective as a “fine tuning” policy instrumentwhen the economy is near full employment. This is particularly true whenthere is an inflationary gap in the economy. In such a case, Keynesianssee the use of contractionary monetary policy as “pulling on a string.”

3. However, Keynesians also believe that in a severe recession or depres-sion, monetary policy is largely ineffective—equivalent to “pushing on astring.” Thus, in the recessionary and depressionary ranges, Keynesiansbelieve that expansionary fiscal policy is much more appropriate.

4. But it was the inability of Keynesian economics to cope with stagflationthat set the stage for Professor Milton Friedman’s monetarist challenge towhat had become the Keynesian orthodoxy.

5. In contrast to the Keynesian orthodoxy, the Monetarist School doesn’tbelieve in an activist fiscal and monetary policy at all. According to MiltonFriedman, the father of monetarism, the problems of both inflation andrecession may be traced to one thing—the rate of growth of the moneysupply. Inflation happens when the government prints too much moneyand recessions happen when it prints too little.

6. More broadly, monetarists like Friedman liken the Federal Reserve to abad driver constantly either accelerating too fast or braking too hard onthe money supply.

7. To fight stagflation and to more broadly prevent the roller coaster ride ofeconomic booms and busts, the monetarist solution is to set monetarytargets and stick with them.

8. These observations lead us to the major paradox of the Keynesian-mon-etarist debate, namely, that it is the Keynesian economists, not the mone-tarists, who support an activist role for monetary policy in fighting reces-sions and inflation.

1. It is sometimes said that war is always good for an economy, but theVietnam War caused a number of economic problems. Why? How havethe wars in Iraq affected the economy?

2. What is monetary policy?

3. How has the Internet and the use of credit cards affected the money andbanking system? Do these technologies make it harder or easier for theFederal Reserve to conduct monetary policy?

4. Has the U.S. Federal Reserve typically done a good job?

5. Name and describe the two sources of money demand.

6. What three characteristics of the modern banking system were also char-acteristics of the early goldsmiths?

7. What are the three instruments of monetary policy? Which is the mostimportant? Why?

8. Describe the monetary transmission mechanism.

9. What is the Keynesian view of monetary policy?

10. What is the monetarist view of monetary policy?

1. Website of the Federal Reserve: Click on the “Monetary Policy” link andthen click on “Open Market Operations”; review the history of the Fed’srate changes, as demonstrated by the changes in the “Intended FederalFunds rate” — www.federalreserve.gov

2. Read some of the Chairman’s speeches under the “Testimony andSpeeches” link in “News and Events” — www.federalreserve.gov

3. Website of the European Central Bank: Get information on how the EBC isorganized and compare it to the Fed’s structure — www.ecb.int

McConnell, Campbell R., and Stanley L. Brue. Chapters 13, 14, and 15.Economics: Principles, Problems, and Policies. 16th ed. New York:McGraw-Hill, 2005.

Navarro, Peter. Chapter 4. If It’s Raining in Brazil, Buy Starbucks. New York:McGraw-Hill, 2001.

Woodward, Bob. Maestro: Greenspan’s Fed and the American Boom. NewYork: Simon & Schuster, 2000.

�FOR GREATER UNDERSTANDING

Websites to Visit

Questions

Suggested Reading

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Unemployment

1. In thinking about the unemploy-ment problem, economists identifythree different kinds: frictional,cyclical, and structural.

2. Frictional unemployment arisesbecause of the incessant move-ment of people between regionsand jobs or through differentstages of their “life cycle.” It is theleast of the economists’ worries.

3. Cyclical unemployment occurswhen the economy dips into arecession, and it is this type ofunemployment that macroecono-mists have historically spentmost of their time trying to solve.

4. Structural unemployment occurswhen there is a mismatchbetween available jobs and the skills workers have to perform them. Itoften results when technological change makes someone’s job obsoleteor when there is a mismatch between the location of workers and thelocation of job openings.

5. In this new century, a different type of structural unemployment hasemerged as more and more jobs have moved offshore. That’s going tomean the acquisition of a new set of skills—if these victims of outsourc-ing are to be fully employed.

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1. Examine more closely three of the most important problems inmacroeconomics: unemployment, inflation, and the combinationof these two problems known as stagflation.

2. Learn about one of the great debates in macroeconomic theory:the so-called “Phillips Curve” and its suggested tradeoffbetween unemployment and inflation.

3. Compare and contrast the Keynesian and monetarist viewsof stagflation.

4. Show the doctrine of supply-side economics as a viable politicalalternative to Keynesianism and monetarism.

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Lecture 5:Unemployment and Inflation:

Enter the Dragons

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6. The distinction between cyclical, frictional, and structural unemploymentis important because it helps economists diagnose the general health ofthe labor market and craft appropriate policy responses.

The Unemployment Rate

1. The unemployment rate is the number of unemployed divided by thelabor force times 100.

In developed countries like the United States, an unemployment ratebetween 4 and 6 percent is considered to be healthy, while over the last100 years in America, this rate has averaged around 5 to 6 percent.

2. Macroeconomists and politicians not only take great interest in the unem-ployment rate, but they also look carefully at unemployment by race, gen-der, and age as well as by education.

The Economic Impact of Unemployment

Okun’s Law was first identified by economist Arthur Okun. By studyingmacroeconomic data, Okun found that for every 2 percent that the grossdomestic product falls in a recession, the unemployment rate rises by aboutone percentage point.

Inflation and Stagflation

1. Inflation has often been described as the cruelest tax, because it eatsaway at our savings and at our paychecks. But not everyone loses frominflation: inflation that is actually unanticipated can benefit borrowers atthe expense of lenders.

2. The essence of demand-pull inflation is “too much money chasing toofew goods.”

3. Cost-push or supply-side inflation occurs when external shocks, suchas rapid increases in raw material prices or wage increases, drive up pro-duction costs. Because cost-push inflation quite literally raises the costsof doing business, it acts as a recessionary force bearing down on theeconomy.

4. Cost-push inflation can end up with“stagflation”—the double whammy ofboth lower output and higher prices.

5. The Keynesian dilemma to fightstagflation was simply this: usingexpansionary policies to reduceunemployment simply created moreinflation while using contractionarypolicies to curb inflation only deep-ened the recession. That meant thatthe traditional Keynesian tools couldsolve only half of the stagflation prob-lem at any one time—and only bymaking the other half worse.

© Clipart.com

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6. It was this inability of Keynesian economics to cope with stagflation thatset the stage first for Professor Milton Friedman’s monetarist challenge towhat had become the Keynesian orthodoxy, and then later for the emer-gence of supply-side economics.

The Phillips Curve

1. Phillips found that wages tended to rise when unemployment was low,but fall when unemployment was high. The clear implication of this rela-tionship is that the unemployment rate tends to fall as the economy’s rateof growth increases, but the inflation rate also tends to rise. Conversely,a decrease in economic growth will increase the unemployment rate butdecrease inflation.

2. This Phillips Curve relationship is perfectly consistent with Keynesianeconomics—but it is at a loss to explain the emergence of stagflation;hence, the Phillips Curve relationship breaks down.

3. According to the monetarists, this disappearance of the Phillips Curvemay best be explained through the concept of the natural rate of unem-ployment and by distinguishing between a short run and a long runPhillips Curve. To the monetarists, it was simply impossible to driveunemployment below the natural or lowest sustainable rate in the longerrun, and this assertion clearly implies that the long run Phillips Curve isvertical rather than downward sloping.

Policy Implications I: Keynesianism and Monetarism

1. The policy implications of the monetarists’ natural rate theory strike to thevery heart of Keynesian activism. To the monetarists, the only way tostop an inflationary spiral is to stop using expansionary Keynesian poli-cies and allow the economy to return to the natural or lowest sustainablerate of unemployment.

2. Nevertheless, even if we stop the upward spiral of inflation, we still havesignificant inflation. This is because a higher core rate of inflation hasbeen built into the economy. The dilemma is that neither the traditionalKeynesian nor the monetarist approach to wringing this inflation out ofthe economy has any political appeal.

3. The traditional Keynesian solution is a so-called “incomes policy”: Imposewage and price controls until the inflation dissipates.

4. Monetarists believe that the only way to wring inflation and inflationaryexpectations out of the economy is to have the actual inflation rate belowthe expected inflation rate. To achieve this, the actual unemployment ratemust be above the natural rate of unemployment, and that means onlyone thing: inducing a recession.

Policy Implications II: Supply-side Economics

1. The conservative school of supply-side economics entered the stageafter the monetarists’ bitter medicine to correct stagflation. Specifically,supply-siders believed that people would actually work much harder and

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invest much more if they were allowed to keep more of the fruits of theirlabor. In such a scenario, the supply-siders promised that by cuttingtaxes and thereby spurring rapid growth, the loss in tax revenues from atax cut would be more than offset by the increase in tax revenues fromincreased economic growth.

2. Unlike the Keynesians, supply-siders did not agree that such a tax cutwould necessarily cause inflation. The end result would be to increasethe amount of goods and services our economy could actually produceby pushing out the economy’s supply curve—hence, supply-side eco-nomics. Moreover, the price level falls even as real output and employ-ment is rising.

3. The so-called “Laffer Curve” relates the marginal tax rate, as measuredon a vertical axis to total tax revenues, as measured on the horizontalaxis. It is backward bending; above a certain marginal tax rate, anincrease in the tax rate will actually cause overall tax revenues to fall.Note also that for a supply-side tax cut to actually increase tax revenues,the existing tax rate before the tax cut must be above m—say at a rateassociated with point n on the curve. (See Figure 5.1)

4. In the 1980 U.S. presidential election, Ronald Reagan ran on a supply-side platform that promised to simultaneously cut taxes, increase govern-ment tax revenues, and accelerate the rate of economic growth withoutinducing inflation. Unfortunately, that didn’t happen: while the economyboomed, so too did America’s budget and trade deficit.

Figure 5.1: The Laffer Curve

© Peter Navarro

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Policy Implications III: New Classical Economics

1. The so-called “twin deficits” deeply concerned Reagan’s successorGeorge Bush, particularly after the budget deficit jumped over $200 bil-lion at the midpoint of his term in 1990 and the economy began to slideinto recession.

2. However, in the Bush White House, Ronald Reagan’s supply-side advi-sors had been supplanted not by Keynesians, but rather by a new breedof macroeconomic thinkers—the so-called “new classical” economists.

3. These new classical economists urged President Bush not to engage inany Keynesian stimulus, and the rest is history. Bush lost to Bill Clinton,largely because of the sluggish economy. However, Bush’s fiscal policyrestraint also helped to set up the United States for its longest economicexpansion in history.

1. Why is the distinction among cyclical, frictional, and structural unemploy-ment important?

2. Explain Okun’s Law.

3. Which is worse, inflation or unemployment? Why?

4. What relationship does the Phillips Curve purport to illustrate?

5. Inflation and stagflation were defined in this lecture, but there is also“deflation.” What is it?

6. Is it possible that the United States could experience another cycle ofstagflation and double-digit interest rates as in the 1970s? Or was that justan unusual event?

7. Do countries such as Brazil, China, and India suffer from the same inflation-ary pressures as developed countries like the United States and Germany?

8. Is the natural rate of unemployment constant? Why or why not?

1. The Bureau of Labor Statistics: On the right-hand side of the screen, you’llfind information about “Employment & Unemployment”; check currentunemployment rates by following the link “State and Local UnemploymentRates” — www.bls.gov

2. On the left-hand side of the screen, find the Consumer Price Index (CPI)and the Producer Price Index (PPI), two of the most followed and watchedinflation indicators; click the respective links and explore how they aremeasured and differ — www.bls.gov

3. The Federal Reserve’s website: Click on the “Monetary Policy” link and goto “Reports” to find the “Monetary Policy Report to the Congress”; followthe link and review the latest testimony: look for insights about the labormarket and prices found in Section 2 of the report —www.federalreserve.gov

McConnell, Campbell R., and Stanley L. Brue. Chapters 8 and 16.Economics: Principles, Problems, and Policies. 16th ed. New York:McGraw-Hill, 2005.

Navarro, Peter. Chapter 15. If It’s Raining in Brazil, Buy Starbucks. NewYork: McGraw-Hill, 2001.

Solow, Robert, and John B. Taylor. Inflation, Unemployment, and MonetaryPolicy. Cambridge, MA: The MIT Press, 1999.

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Websites to Visit

Questions

Suggested Reading

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Absolute Advantage vs.Comparative Advantage

(See Figure 6.1)

1. The idea of absolute advan-tage as a basis for trade wasfirst set forth by Adam Smith inthe 1700s. Smith said that acountry that can produce agood at a lower cost thananother country will have an absolute advantage in the production of thatgood.

2. At first glance, the principle of absolute advantage appears to makesense. Nonetheless, it has a significant implication, and one that is badlyflawed. The more subtle understanding of why this happens is embodiedin the theory of comparative advantage.

3. The theory of comparative advantage was first set forth in 1817 by theEnglish economist David Ricardo. This principle holds that each countrywill benefit if it specializes in the production and export of those goodsthat it can produce at a relatively lower cost than other countries.Conversely, each country will benefit if it imports those goods that it pro-duces at relatively higher cost.

4. Note that this simple principle of comparative advantage—although onemore subtle than the principle of absolute advantage—provides theunshakable basis for international trade.

5. The theory of comparative advantage is one of the fundamental princi-ples of economics; and nations that disregard the lessons of comparativeadvantage and try to hide behind protectionist trade barriers will pay aheavy price in terms of their living standards and economic growth.

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1. Examine the economic principles governing international tradeand demonstrate the gains from trade.

2. Explore some of the many political pressures that can ariseamong countries over large deficits and lead to the so-calledprotectionism and trade barriers.

3. Learn some basic “balance of payments” accounting.

4. Examine important multilateral trade agreements, such as thoseembodied in the World Trade Organization.

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Lecture 6:International Trade and Protectionism:

Where Did Our Jobs Go?

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Figure 6.1: Comparative Advantage Example

© Peter Navarro

Tariffs and Quotas

1. A tariff is simply a tax on imports that is collected by the government.When a tariff is imposed, domestic producers and the government win.However, the big loser is the consumer, and the broader economy losesas well. Together with the reduction in consumer welfare, this creates anefficiency loss that economists often refer to as a “dead weight loss.”

2. A quota is an explicit quantity limit on imports. The only real differencebetween a tariff and a quota is that with a quota there are no revenuespaid to the government.

3. From a political standpoint, it is a bit easier for a country to impose quo-tas than tariffs because there is less harm to the foreign producers—andtherefore less political pressure on a foreign government to retaliate withtariffs or quotas of its own.

4. Many nations also use so-called non-tariff barriers (NTBs). NTBs, whichinclude quotas, also consist of formal restrictions or regulations that makeit difficult for countries to sell their goods in foreign markets.

Arguments in “Support” of Protectionism

1. For starters, there is the national defense or military self-sufficiency argu-ment. This is not an economic argument, but rather a political and strate-gic one. Unfortunately, there is no objective criterion for weighing theworth of an increase in national security relative to a decrease in eco-nomic efficiency accompanying the reallocation of resources towardstrategic industries.

2. A second argument for protectionism is to save jobs. This is an argumentthat often becomes politically fashionable when a country enters a reces-sion. One problem with this argument has to do with the fallacy of com-position. The use of tariffs and quotas to achieve domestic full employ-ment are termed “beggar thy neighbor” policies.

3. Closely related is the dumping argument. Dumping occurs when foreignproducers sell their exports at a price less than the cost of production.Because dumping is a legitimate concern, it is prohibited under interna-tional trade law; nevertheless, dumping still goes on.

4. The fourth argument for protectionism is called the terms of trade or opti-mal tariff argument. The idea here is to impose a tariff that will shift theterms of trade in a country’s favor and against foreign countries.

5. Finally, a favorite argument in support of protectionism in developingcountries is the so-called “infant industry argument.” The idea here is thattemporarily shielding young domestic firms from the severe competitionof more mature and more efficient foreign firms will give infant industriesa chance to develop and become efficient producers. Historical evidencesuggests that this argument must be weighed cautiously.

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GATT Treaty

1. The General Agreement on Tariffs and Trade Treaty, or so-called GATTTreaty, was established at the end of World War II. At the beginning of1995, it became the World Trade Organization (WTO).

2. Every few years, representatives of the major industrialized countriesmeet together for a round of trade talks aimed at reducing both tariffs andNTBs. At least thus far, with every round of the WTO, trade barriers havefallen further around the globe.

Balance of Payments

1. An open economy is simply one that engages in international trade. Auseful measure of such openness is something economists call the“trade share,” which is simply the ratio of a country’s exports or importsto its GDP.

2. The current account consists of three major items: the merchandise tradebalance, fees for services, and net investment income.

3. The merchandise trade balance reflects trade in commodities such asfood and fuels and manufactured goods, and is by far the biggest item.When the United States is running a “trade deficit,” it is this merchandisetrade balance to which journalists often are referring to.

4. Fees for services include shipping, financial services, and foreign travel.While this fees category is much smaller than the merchandise trade bal-ance, it has grown in recent years as the United States has shifted froma manufacturing economy to a more service-oriented economy.

5. The third item in the current account is investment income. Historically,this category has run a small surplus for the United States. However,as foreigners have continued to accumulate more and more U.S.assets, this category has started to run in the red, further exacerbatingthe trade deficit.

6. Finally, the fourth item in the current account is unilateral transfers. Thiscategory represents other kinds of payments that are not in return forgoods and services.

7. The trade identity equation refers to an important accounting relationshipbetween the current account and the capital account. If a country such asthe United States runs a trade deficit in its current account, it must bal-ance that deficit with in-flows into its capital account.(See Figure 6.2)

8. One part of the capital account shows “official-reserve changes.” Whenall countries have purely market-determined exchange rates, the catego-ry equals zero. However, when countries intervene in foreign exchangemarkets, it shows up in the balance of payments as changes in officialreserves.

9. Of far greater consequence are the capital out-flows and in-flows, whichtrack the purchases of real assets like hotels, factories, and golf coursesand financial assets such as stocks and bonds.

Trade Deficits and Budget Deficits

1. To many observers, America’s chronic trade deficits are every bit as dan-gerous as its chronic budget deficits. These “trade deficit hawks” warnthat America is being forced to sell off its land and its factories—and itsfuture—to finance these deficits.

2. Others, however, see the trade deficits simply as an opportunity to buyinexpensive foreign goods and enjoy a higher standard of living thanAmericans could otherwise achieve. These “trade deficit doves” arguethat if foreign countries are foolish enough to sell us cheap goods, weshould be wise enough to buy and enjoy them and not try to erect protec-tionist trade barriers.

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Net CreditsU.S. BALANCE OF PAYMENTS Credit Debit or Debits

Current Accounta. Merchandise Trade Balance -191U.S. Goods Exports 612U.S. Goods Imports -803

b. Fees for Services 80U.S. Exports of Services 237U.S. Imports of Services -157

Balance on Goods and Services -111

c. Net Investment Income 3Income earned by U.S. 206Investors holding foreign assetsIncome earned by foreigners -203holding U.S. assets

d. Unilateral Transfers -40

Balance on the Current Account -148

Capital Accounta. Foreign purchases of assets 517in the U.S.

b. U.S. purchases of assets abroad -376Balance on Foreign/U.S. Purchases 141

c. Official reserves 7

Balance on Capital Account -148

Sum of Current andCapital Accounts -0-

Figure 6.2Balance of Payments

©PeterNavarro

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1. Compare the theories of absolute advantage and comparative advantage.

2. What is the difference between a tariff and a quota?

3. From a political standpoint, why are quotas often preferred to tariffs?

4. Write down the five major arguments in support of protectionism and givean example for each one.

5. According to most economists, the WTO is a good thing. Yet every timethe WTO countries meet, there are large-scale demonstrations. Why?

6. How does a country like the United States, whose workers earn highwages and whose businesses must contend with strong environmentalprotection regulations, ever compete against developing nations likeMexico, China, or Brazil, which have large, low-paid workforces and few, ifany, environmental regulations?

7. What about countries like China and the Philippines, which copy newtechnologies and software without paying the appropriate royalties? Howdoes the world trading system deal with that?

8. In an age of terrorism, is the free trade of goods really in the world’s inter-est if terrorists can obtain any of the new technologies they want?

1. Read more about balance of payments by visiting the IMF website: usethe search engine to find “Balance of Payments and InternationalInvestment Position Statistics” — www.imf.org

2. The Bureau of Economic Analysis: Click on “Balance of Payments” underthe “International” link and check the latest news release of the UnitedStates’ current account deficit — www.bea.gov/beahome.html

3. Spend some time browsing the WTO; you can also download the“Understanding the WTO” brochure for future reference —http://www.wto.org

McConnell, Campbell R., and Stanley L. Brue. Chapters 6 and 37.Economics: Principles, Problems, and Policies. 16th ed. New York:McGraw-Hill, 2005.

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Exchange Rates

1. An exchange rate is simply the rate atwhich one nation’s currency can be tradedfor another nation’s currency.

2. Note that exchange rates can fluctuaterather markedly. Three basic reasonsexplain fluctuations amongexchange rates.

3. The first has to do with the different ratesof growth across countries. For example,if the U.S. GDP is growing faster than theJapanese GDP, the U.S. dollar will depre-ciate relative to the Japanese.

4. Exchange rates can also fluctuate with achange in relative interest rates. For exam-ple, when U.S. interest rates rise relative toBritish interest rates, the dollar will appreciate relative to theBritish pound.

5. The third reason why exchange rates shift is because of different rates ofinflation. For example, if the rate of inflation in Canada is higher than inEurope, the Canadian dollar will depreciate relative to the Euro.Economists call this the “law of one price.”

6. A floating exchange rate system is one in which the exchange rates ofcurrencies like the pound and the dollar are allowed to float freely and bedetermined by market forces.

7. Not all countries in the international monetary system allow theirexchange rates to be determined in such a “flexible” or “floating”exchange rate system. In fact, some countries use what is called a fixedexchange rate system in which governments determine the rates atwhich currencies are exchanged and then make the necessary adjust-ments in their economies to ensure that these rates continue.

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LECTURESEVEN

LECTURE OBJECTIVES

1. Describe how exchange rates work and how the internationalmonetary system is structured.

2. Learn the important link between the budget and trade deficits.

3. Understand why it is increasingly important for the nations ofthe world to coordinate their fiscal and monetary policies in aglobal economy.

Lecture 7:The International Monetary System,Exchange Rates, and Trade Deficits

41

The Gold Standard

1. Between 1867 and 1933, except for the period around World War I, mostof the nations of the world were on the gold standard. Under this fixed-exchange-rate system, the currency issued by each country had to eitherbe gold or redeemable in gold. Once a country agreed to be on the goldstandard, its currency was convertible into a fixed amount of gold.

2. With these fixed exchange rates, if a nation ran a trade deficit, it wouldbe required to use its gold reserves to buy currency to prevent the valueof the currency from falling. In contrast, if a nation ran a trade surplus, itwould accumulate gold.

3. The gold standard was so popular because of the gold specie flow mech-anism. This monetary adjustment mechanism was first described byScottish philosopher and economist David Hume in 1752. The net effectof this gold specie flow trade adjustment is that a balance-of-paymentsequilibrium is restored among countries. (See Figure 7.1)

4. The world’s fixed-exchange-rate system based on the gold standardworked reasonably well at stabilizing the currency markets right up untilWorld War I. However, with the advent of the war, many nations had totemporarily abandon the gold standard to finance their war efforts. Thisled to differing rates of inflation in different countries, which distort the rel-ative value of currencies.

5. With the collapse of the gold standard in the 1930s, countries desperateto create jobs in a depressionary global economy engaged in so-calledcompetitive devaluations. However, these competitive devaluations actedlike a “beggar thy neighbor” trade policy. These economic pressures, inturn, contributed to growing political pressures that eventually led toWorld War II.

Figure 7.1: Gold Specie Flow Mechanism

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LECTURESEVEN

Bretton Woods

1. The harsh lessons of the 1930sgave birth to a new internationalmonetary system. The new systemfeatured a modified fixed exchangerate system called a partially fixed oradjustable peg system. This systemreplaced the gold standard with aU.S. dollar standard, and the U.S.dollar was designated as the world’skey currency.

2. Note, however, that Bretton Woodsalso provided for a cooperative mechanism in which the exchange rateswere only partially fixed. These new partially fixed rates could be periodi-cally adjusted to reflect changes in currency values in a process knownas adjusting the peg.

3. In August of 1971, a reluctant Nixon Administration abandoned the dollarstandard and the Bretton Woods system collapsed. No longer would dol-lars be redeemable for gold at $35 an ounce, and in the wake of thatabandonment, the dollar’s value fell precipitously.

The Current Exchange Rate System

1. The world has moved to a hybrid system known as the managed float,which has four major features.

2. First, a few countries like the United States have a primarily flexible or“floating” exchange rate. In this approach, markets determine the curren-cy’s value, and there is very little intervention.

3. Second, other major countries such as Canada, Japan, and, morerecently, Britain have managed-but-flexible exchange rates. Under thissystem, a country will buy or sell its currency to reduce the day-to-dayvolatility of currency fluctuations. A country may also engage in system-atic intervention to move its currency toward what it believes to be amore appropriate level.

4. Third, some countries join together in a currency bloc in order to stabilizeexchange rates among themselves while allowing their currencies tomove flexibly relative to those of the rest of the world. The most importantof these blocs is the European Monetary System, which has adopted thatsingle currency we call the Euro.

5. Fourth, many countries use a variation on the old fixed-exchange-ratesystem by pegging their currencies to a major currency such as the dollaror to a “basket” of currencies. Sometimes, this peg is allowed to glidesmoothly upward or downward in a system known as a gliding or crawl-ing peg. Other times it is tightly fixed.

U.S. Trade Deficits

1. The first contributor to explain the trade deficits may be traced to thelarge, chronic budget deficits that the United States began to run in the

U.S. Delegates to the Bretton Woods Conference,July 22, 1944

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43

1980s. The need for the government to finance these budget deficitsdrove up interest rates. This strengthened the dollar as foreigners had tofirst buy dollars in order to buy U.S. bonds, thus resulting in a strongerdollar that made exports more expensive and imports cheaper, and sentthe trade deficit spiraling upward.

2. A declining savings rate in the United States has also been a major con-tributing factor to the trade deficit problem. As the U.S. savings rate hasfallen, the investment rate has remained fairly stable or even increased.This has been possible because foreign investment has filled the sav-ings-investment gap. In this sense, the U.S. capital surplus may not onlyresult from the trade deficit but also help to cause it.

3. A third reason is that the U.S. economy has grown at a faster pace thaneither Europe or Japan, as well as many of its major trading partners.This growth in U.S. income has boosted import consumption even asrecessions or stagnation in countries like Japan and Canada hasdepressed their purchases of U.S. exports.

4. Perhaps what is most interesting about these three major causes of theU.S. trade deficit is that they are all driven in some degree by arguablyirresponsible U.S. domestic fiscal and monetary policies.

Active Policies and the Global Economy

1. The conduct of domestic fiscal and monetary policies in a global econo-my can affect not only the domestic country’s trade balance, but also sig-nificantly affect the rates of growth and unemployment in the domesticcountry’s trading partners. Any imbalances in either capital or trade flowsin one country will affect all trading partners.

2. For example, America’s domestic and contractionary fiscal policy can notonly lead to a contraction in the American economy but also function as acontractionary fiscal policyfor Europe as well.Economists refer to thischain of causality as the“multiplier link.” (SeeFigure 7.2)

3. Moreover, in its attempt to fight domestic inflation by raising U.S. interestrates, the Federal Reserve of the United States may well increase thechance that Europe will experience a recession. Economists refer to thischain of events as the “monetary link.” Unlike with fiscal policy and themultiplier link, the overall impact of monetary policy and the monetary linkon domestic GDP is ambiguous and depends on the particular situation.(See Figure 7.3)

Figure 7.2: The Multiplier Link

©PeterNavarro

©PeterNavarro

Figure 7.3: The Monetary Link

1. Explain the three major reasons why exchange rates change.

2. Is it better for a country like the United States to have a weak or astrong currency?

3. Explain the gold specie flow mechanism.

4. When and why did Bretton Woods collapse?

5. What are the three major causes of the chronic trade deficits of theUnited States?

6. Explain some of the difficulties of coordinating macroeconomic policiesamong countries.

7. When are trade wars most likely to happen?

8. Will the world eventually move to one currency?

1. The United States’s trade deficit has its own governmental commission;browse the “Reports” section for the final report of the U.S. trade deficit;compare the Democrats’ and Republicans’ diagnoses of the causes andconsequences of the chronic trade deficits and their recommendations forfuture action — http://govinfo.library.unt.edu/tdrc

2. Click on “Market Data,” select “Currencies,” and examine exchange ratesby clicking on “Benchmark Currency Rates” and “World Currencies” —www.bloomberg.com

3. Information about the Euro — www.europa.eu.int/euro/entry.html

McConnell, Campbell R., and Stanley L. Brue. Chapter 38. Economics:Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.

Navarro, Peter. Chapter 18. If It’s Raining in Brazil, Buy Starbucks. NewYork: McGraw-Hill, 2001.

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LECTURESEVEN

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45

Introduction to Microeconomics

1. The study of microeconomicsdeals with the behavior of individ-ual markets and the businesses,consumers, investors, and work-ers that make up the macro econ-omy. Microeconomics can help toanswer questions at a profession-al and personal level. Most broad-ly, microeconomics can also helpyou to come to understand whythe government is so involved inour economic lives.

2. Three basic facets of economicand political life must beaddressed by any economy:scarcity, efficiency, and equity.

3. The concept of scarcity is related to that of economics goods (that is,goods that are scarce or limited in supply). While goods are limited,wants are seemingly limitless. This undeniable fact prompts an economyto choose among different potential bundles of goods (the “what”), selectfrom different techniques of production (the “how”), and decide in the endwho will consume the goods (the “for whom”).

4. Efficiency denotes the most effective use of a society’s resources in sat-isfying people’s wants and needs. Allocating resources efficiently is allthe more complicated because in pursuing efficiency, there is almostalways a thorny tradeoff between what is efficient from an economic point

© Recorded Books, LLC/Ed White

LECTURE OBJECTIVES

1. Illustrate how important microeconomics can be in your personaland professional life.

2. Introduce the supply and demand curves and explain how the forcesof supply and demand lead to an equilibrium in the market and setmarket prices.

3. Show how market price reaches its competitive equilibrium at pre-cisely where the demand and supply curves cross—where the forcesof demand and supply are just in balance.

4. Introduce the notion of artificial price controls into the free market.

5. Show the advantages of the free market in determining pricesand quantities.

Lecture 8:Supply, Demand, and Equilibrium:How Prices Are Set in Our Markets

LECTUREEIGHT

46

of view and what may be viewed as “fair” or “equitable” from a social andpolitical point of view.

5. In fact, grappling with the tradeoff between efficiency and equity is one ofthe most difficult tasks of economists and the political and business lead-ers they serve. In a similar vein, we see that almost any time the govern-ment tries to raise taxes to redistribute income from the rich to the poorthrough mechanisms like food stamps or Medicare, those taxes tend tointerfere with the efficiency of the free market.

Supply and Demand and Equilibrium

(See Figure 8.1)

1. The implication of a downward-sloping demand curve is that the lowerthe price, “ceteris paribus” (Latin for other things constant), the moreunits a consumer will demand. And the higher the price, again holdingother things constant, the less the consumer will demand. This is calledthe Law of Demand.

2. The quantity demanded of a good tends to fall as its price rises becauseof the substitution effect and the income effect.

3. The demand curve can shift outwards, indicating higher demand—orinwards, indicating lower demand. These demand shifts can occurbecause of shift factors, such as changes in the average income of con-sumers, prices of substitute goods, and consumer tastes.

4. The supply curve slopes up. The so-called Law of Supply says that thelower the price, holding other things constant, the fewer firms will pro-duce, and the higher the price, holding other things constant, the morefirms will produce.

Figure 8.1: The Computer Market (Supply and Demand)© Peter Navarro

47

5. The location and slope of the supply curve depends on the firm’s abilityto produce—to transform the so-called “factors of production” like rawmaterials and labor and capital into consumable goods. However, supplyalso depends on the individual’s decisions to supply the factors of pro-duction to begin with.

6. The supply curve is influenced by shift factors such as technology, inputprices, and government policies.

7. Finally, the demand and supply curves naturally cross at the point wherewe are likely to find the market equilibrium—which tells us how much ofthe good is sold in the market and at what price.

8. In supply and demand analysis, equilibrium means that the upward pres-sure on price is exactly offset by the downward pressure on price. Theequilibrium price is the price toward which the invisible hand drives themarket and is reached at the point where demand and supply are in bal-ance and the market clears—at the intersection of supply and demand.

9. A surplus in the market is an excess of quantity supplied over quantitydemanded. A shortage is an excess of quantity demanded overquantity supplied.

Price Controls

1. Price support programs set the so-called “price floors”: if the market pricefell below the floor, the government would make up the difference to thesubsidized by buying up any surplus. In this case, the price floor works toprop up price above the free market equilibrium—and thereby helps thesubsidized, albeit at the expense of consumers.

2. The so-called “price ceilings” may be instituted by the government. In sucha case, the market price might be well above the price ceiling and at thisprice ceiling, consumers will demand far more than the market is willingto supply.

The Free Market Mechanism

1. First, because it is the market determining the equi-librium prices and quantities of all inputs and out-puts, it is the free market—not the government—that is allocating or rationing out the scarce goodsof society among the possible uses.

2. Second, it is the market and its many price signalsthat determine just what goods are produced. Forexample, high oil prices stimulate oil production,whereas low food prices drive resources outof agriculture.

3. Third, the market can also answer the question: Forwhom are goods produced? This is because it is thepower of the purse that dictates the distribution ofincome and consumption.

© PhotoDisc

1. How can microeconomics help you at a business and professional level?

2. How can microeconomics help you at a personal level?

3. How is microeconomics distinguished from macroeconomics?

4. Several examples were given of how an understanding of microeconomicscould help you as an investor. Could you provide another one?

5. An improvement in technology can have a positive impact on a marketby shifting the supply curve outward and lowering prices that consumershave to pay. What is the broader effect of such technology shocks onthe economy?

6. Summarize the various reasons why the government might intervene in theprivate marketplace.

7. President Roosevelt established price supports during the GreatDepression for wheat and corn and other agricultural products. Did it makesense to raise the price of food during this time when people were havingsuch a hard time making ends meet?

1. The website of Professor Gary Becker, the 1992 Nobel Laureate inEconomics: Click on the “Business Week Articles” tab and read the articlesrelated to regulation and family from the archive —http://home.uchicago.edu/~gbecker

2. The Federal Trade Commission (FTC); choose “For Consumers” and “ForBusiness” options to get a flavor of how microeconomics is embedded inyour daily personal and professional life — www.ftc.gov

3. The Foundation of Economic Education: a research organization that pro-motes free markets and limited government intervention — www.fee.org

McConnell, Campbell R., and Stanley L. Brue. Chapters 1, 2, 3, and 3W(Web). Economics: Principles, Problems, and Policies. 16th ed. New York:McGraw-Hill, 2005.

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LECTUREEIGHT

49

Consumer Choice and Utility Theory

1. Using the theory of self-interest,economists explain that consumerchoice boils down to three factors:the pleasure people get from con-suming a good, the price they haveto pay for it, and the income or bud-get available to them to exercisetheir choices.

2. In order to measure pleasure, econ-omists have settled for what is calledan ordinal measure of utility, whichranks the desirability of goods rela-tive to one another.

3. It is nonetheless very convenient toassume that economists can, in fact,actually use numbers to measureutility. The cardinal measure of utilityand the related notion of “util” areused to build demand curves.

4. Two very important principles in eco-nomics are those of “total utility” and“marginal utility.”

5. Total utility is defined as the satisfaction we get from consuming some-thing, while marginal utility is defined as the incremental or additional utili-ty you get from consuming the next unit of a good. Indeed, one of themost important laws in economics is that while total utility increases withconsumption, it does so at a decreasing rate or that there is a diminishingmarginal utility.

The Equimarginal Principle and Utility Maximization

1. We assume that consumers maximize utility subject to a budget orincome constraint. Hence, consumers have a certain amount of income

©PhotoDisc

LECTURE OBJECTIVES

1. Learn about the intricacies of consumer behavior.

2. Introduce important new concepts such as cardinal versus ordinalutility, diminishing marginal utility, and demand price elasticity.

3. Understand the nature of the demand curve in economics—par-ticularly why the demand curve slopes downward and has aninverse relationship to price.

Lecture 9:Understanding Consumer Behavior:

The Essential Elements

50

to spend and, subject to their budget constraint and given a menu ofprices, they choose a market basket of goods that provides them with thegreatest utility or satisfaction.

2. Consumers do maximize their utility by following the utility-maximizingrule or equimarginal principle. A consumer with a fixed income facingmarket prices will achieve maximum satisfaction when the marginal utilityof the last dollar spent on each good is exactly the same as the marginalutility of the last dollar spent on any other good.

3. Moreover, the equimarginal principle perfectly explains why demandcurves slope downward. Suppose that at the equilibrium point, we holdthe marginal utility per dollar constant for two goods. Then, further sup-pose that the price of good x increases. Then, the marginal utility per dol-lar of good x must fall below the same ratio for good z, implying a down-ward sloping demand curve. This is because as the price of good x rises,quantity demanded falls.

The Price Elasticity of Demand

(See Figure 9.1 and Table 9.2)

1. The price elasticity of demand measures how much consumers willincrease or decrease their quantity demanded in response to a price

Table 9.1: Example: Elasticity of Demand

Dove Bar Big MacDove Bar price = $1 Big Mac price = $2

Marginal Marginal utility Marginal Marginal utilityUnit of utility, per dollar utility, per dollarProduct utils (MU/price) utils (MU/price)

First 10 10 24 12

Second 8 8 20 10

Third 7 7 18 9

Fourth 6 6 16 8

Fifth 5 5 12 6

Sixth 4 4 6 3

Seventh 3 3 4 2

Marginal utilityPotential choice per dollar Purchase decision Income remaining

First Big Mac 12 First Big Mac for $2 $8 = $10–$2First Dove Bar 10

First Dove Bar 10 First Dove Bar for $1 $5 = $8–$3Second Big Mac 10 and second Big Mac for $2

Second Dove Bar 8 Third Big Mac for $2 $3 = $5–$2Third Big Mac 9

Second Dove Bar 8 Second Dove Bar for $1 $0 = $3–$3Fourth Big Mac 8 and fourth Big Mac for $2

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change. A big change in quantity demanded when the price changesmeans demand is elastic and a small change in quantity demanded whenthe price changes means demand is price inelastic.

2. A relativelyflat demandcurve for theprice-elasticgood wouldbe observed.This showsthat a smallchange inprice leads toa big changein quantitydemanded.

3. A relativelysteep demandcurve for theprice-inelasticgood isexpected tobe observed.Even with abig change inprice, thequantitydemandeddoesn’tchange much.

Figure 9.1: Elasticity of Demand

© Peter Navarro

Price Elasticities for aVariety of Products

Product or Service Elasticity of Demand

Housing .01

Electricity (household) .13

Bread .15

Telephone Service .26

Medical Care .31

Eggs .32

Legal Services .37

Automobile Repair .40

Clothing .49

Milk .63

Household Appliances .63

Movies .87

Beer .90

Shoes .91

Motor Vehicles 1.14

China, Glassware, etc. 1.54

Restaurant Meals 2.27

Lamb and Mutton 2.65

Table 9.2: Price Elasticities

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LECTURENINE

4. The concept of the price elasticity of demand has tremendous applicationin the pricing and marketing strategies of both businesses and govern-ment agencies. It also helps us to better understand many aspects ofpublic policy. The demand elasticity helps both businesses and govern-ment agencies think about how to price their products and services.

Determinants of Price Elasticity of Demand

1. On the one hand, necessities like housing, electricity, and bread are veryprice inelastic. On the other hand, goods that tend more toward beingluxuries, such as restaurant meals and glassware, are price elastic.

2. Besides whether a good might be considered a luxury or a necessity,other important factors that determine the price elasticity are the numberof substitutes for a good, how you define a good, the proportion ofincome, and time.

3. Economists define complement goods as those that are consumed jointlyto satisfy consumers’ wants and needs. If the demand of one comple-ment product goes up, the demand for the other one goes up as well.

4. In contrast, substitute goods refer to the case where an increase inthe price of one good determines the decrease in the demand for theother good.

5. Economists measure the degree of a product’s substitutability or comple-mentariness by estimating so-called “cross-price elasticity.”

The Income Elasticity of Demand

1. As for the equally interesting distinction between so-called normal goodsand inferior goods, these relate to the income elasticity of demand.

2. The idea of a normal good is that people will buy more of it as theirincomes increase. Houses, luxury cars, and steak fit neatly intothat category.

3. In contrast, rental units, mass transit, and potatoes are inferior goodsbecause people will buy less of these goods as their income rises—asthey switch to own-ing their ownhomes, buyingcars, and eatingbetter quality food,like steak.

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1. Consumer choice boils down to what three things?

2. Explain the law of diminishing marginal utility.

3. State the utility-maximizing rule or the equimarginal principle.

4. What are the four major determinants of price elasticity of demand?

5. Why don’t most new cars sell at their sticker price?

6. Why do many farmers go bankrupt when crops are plentiful?

7. If the government imposes a sales tax on a product that is highly elastic,what will happen to total tax revenues?

8. This idea of elasticity seems like a really powerful one. Why do so manybusiness executives keep making the same mistake of trying to raiseprices in a recession to boost revenues when they are selling productswith elastic demands?

9. Some material introduced in this lecture is technical, and it was mentionedthat college students in economics have to learn about the mathematics ofall of this. Am I missing anything by skipping the mathematics?

10. Henry Ford only wanted to sell black Model Ts, but if you go into a gro-cery store today, you can buy fifty different kinds of plain old cerealdressed up in sugar or chocolate or colors or shapes. Is there any suchthing as too much consumer choice?

1. To see how price elasticity works, click on “Microeconomic Principles” andthen choose “Elasticity Measures” and experiment with the applet includedin the page — www.digitaleconomist.com

2. Not all economists adhere to the notion of the utility theory as it isassumed by mainstream microeconomics; check the National ScienceFoundation website and use the search engine included in the webpage;type “utility theory” and you will find a brief article questioning utility theory— www.nsf.gov

McConnell, Campbell R., and Stanley L. Brue. Chapters 20 and 21.Economics: Principles, Problems, and Policies. 16th ed. New York:McGraw-Hill, 2005.

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LECTURETEN

Production Function

The production functionspecifies the maximumoutput that can be pro-duced with a given quanti-ty of inputs for a givenstate of engineering andtechnical knowledge.

Short vs. Long Run

1. The short run is the periodin which firms can adjustproduction only by changing variable factors, such as materials andlabor, but cannot change fixed factors, such as capital.

2. The long run is a period sufficiently long enough so that all factors in theproduction function, including capital, can be adjusted.

3. The distinction between the short and long run is important in productiontheory because each period has its own kind of cost analysis.

Short Run Cost Analysis

(See Table 10.1)

1. The firms’ fixed costs, sometimes called “overhead,” are those costs thatdo not change with the level of output. Examples of fixed costs includerent, interest on the bonds, insurance premiums, and the salaries oftop management.

2. Variable costs are those costs that change with the level of output. Forexample, when you increase production to meet demand, you have topay for more raw materials and fuel. You also have to pay more in wagesto cover the increased overtime and additional workers.

3. The total cost is simply variable costs plus fixed costs.

4. Marginal cost is the additional cost incurred in producing one extra unit ofoutput. It is arguably the most important kind of cost.

LECTURE OBJECTIVES

1. Understand the theory of production and analyze how firms pro-duce and offer goods for sale.

2. Recognize the difference between short-run and long-run costs,marginal cost, and the law of diminishing returns, economies ofscale, and the shapes of various cost curves.

3. Introduce the Structure-Conduct-Performance paradigm and thefour forms of market structure.

Lecture 10:Producer Behavior and

an Introduction to Perfect Competition

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Short Run Cost Analysis

1 2 3 4 5 6 7 8Marginal costs Average Average variable Average

Fixed Variable Total (MC) fixed costs fixed costs costs (ATC)costs costs costs (change in (AFC) (AVC) (ATC)

Output (FC) (VC) (TC) total costs) FC/Output VC/Output AFC+AVC

4 50 50 100 12.50 12.50 25.00

5 50 60 110 10.00 12.00 22.00

10 50 100 150 5.00 10.00 15.00

11 50 106 156 4.54 9.64 14.18

17 50 150 200 2.94 8.82 11.76

18 50 157 207 2.78 8.72 11.50

21 50 182 232 2.38 8.67 11.05

23 50 200 250 2.17 8.70 10.87

24 50 210 260 2.08 8.75 10.83

28 50 250 300 1.79 8.93 10.72

29 50 265 315 1.72 9.14 10.86

32 50 350 400 1.56 10.94 12.50

10

6

7

10

15

5. The Law of Diminishing Returns states that if one factor of production isincreased while the others remain constant, the overall returns will rela-tively decrease after a certain point.

Average Fixed Cost, Average Variable Cost, and Average Total Cost

(See Figure 10.1)

1. First, the average fixed cost (AFC) curve slopes downward andapproaches zero on the horizontal axis, while the average variable cost(AVC) curveapproaches theaverage totalcost (ATC)curve. The aver-age fixed cost(AFC) curvemust approachzero, because asa firm’s outputincreases, itspreads its fixedcosts over alarger numberof units, so aver-age fixed costs

Table 10.1: Short Run Cost Analysis

Figure 10.1: AFC, AVC, and ATC Curves

©PeterNavarro

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LECTURETEN

must fall. Similarly, the AVC curve must approach the ATC curve asoutput increases.

2. The marginal cost (MC) curve intersects both the AVC and AC curves attheir minimums. If the marginal cost is greater than average total cost,then the average total cost must be rising, and vice versa. Thus, it mustbe that only when marginal cost equals average total cost that the ATC isat its lowest point. This is a very critical relationship. It means that a firmsearching for the lowest average cost of production should look for thelevel of output at which marginal cost equals average cost.

Long Run Cost Analysis

(See Figure 10.2)

1. The long run average cost curve is the envelope of the short run averagecost curves. For example, for any given plant scale, capital inputs arefixed in the short run and there is a point on the average total curvewhere average cost is minimized. Now, if you build a bigger plant, outputwill increase, and there will be another short run ATC curve created. Andeach point on this bumpy planning curve shows the least unit cost obtain-able for any output when the firm has had time to make all desiredchanges in plant size.

2. The reason forthe U-shape ofthe long runaverage costcurve is notthe law ofdiminishingreturns.Instead, theexplanationlies in under-standing oneof the mostimportant con-cepts in eco-nomics, knownas economiesof scale:economies ofscale are said to exist when the per-unit output cost of all inputsdecreases as output increases. As to why such economies of scale mayexist, they may be traced to such factors as increased labor and man-agerial specialization and more efficient capital use. Finally, economiesof scale are not necessarily present in all industries.

Figure 10.2: The Long-Run Average Cost Curve

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Shapes of the Curves

(See Figure 10.3)

1. The first graph on the top left shows the broad U-shaped curve weobserved earlier.

2. The second graph on the top shows a narrow and steep U-shape, whichindicates that economies of scale are exhausted quickly, so that mini-mum unit costs will be encountered at a relatively low output. The typicalprofile of an industry characterized by this kind of V-shaped curve isnumerous sellers and healthy competition.

3. The third graph, bottom left, shows a flat segment, characteristic of con-stant returns to scale. Rather than a smooth U-shape, there is a long flatspot in the middle of the curve over which unit costs do not vary withsize. It has important implications for business executives contemplatingstrategic decisions such as mergers and acquisitions.

4. In the fourth graph, bottom right, we have what’s called increasing returnsto scale over the relevant range of output. With a natural monopoly, unitcosts steadily fall as plant size increases over a large range. In particular,the natural monopoly shape of the curve means that over time, biggerproducers will drive out smaller producers until there is only one producerleft—the infamous monopolist.

Market Failure

1. The result of the so-called market failure is that price will be set too highand output too low for market efficiency, and government regulation maybe warranted. That’s why economists often argue that natural monopolieslike railroads, electricity, and gas distribution should be regulated.

Figure 10.3: The Long-Run ATC (Shapes)

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2. Minimum efficient scale is defined as the smallest level of output that afirm can minimize long-run average costs. This important concept cangive rise to another type of industry structure known as oligopoly, whichis characterized by a small number of large sellers. Examples includeautomobiles, aluminum, steel, and cigarettes.

The Structure-Conduct-Performance Paradigm

(See Figure 10.4)

1. The central concept driving this paradigm is that industry structuredetermines market conduct, and market conduct, in turn, determinesmarket performance.

2. Marketconductembodiesthe variouspricing andmarketingtactics andstrategiesof business-es. Suchconductincludes notonly at whatlevel a firmor industrysets its priceand output,but alsowhether thatfirm orindustryengages invariouskinds ofnonpricecompetition through product differentiation and advertising.

3. The different types of market conduct in turn drive market performancewhere performance is measured by yardsticks such as allocative andproductive efficiency. These yardsticks can tell us how well—or poorly—a society’s resources are being used.

4. Market structure refers to how many firms are in an industry, whether thefirms are big or small, what the firms’ cost structures look like, and howmarket share is divided among the firms. The four major types of marketstructure include perfect competition, monopolistic competition, oligopoly,and monopoly.

Figure 10.4: Structure, Conduct, Performance

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The Four Forms of Market Structure

(See Figure 10.5)

From a practicalpoint of view,the most impor-tant feature ofeach form ofmarket struc-ture is thedegree of pric-ing and marketpower that eachform of marketstructure givesto the partici-pants inthat market.

PerfectCompetition

1. Perfect competi-tion is the mar-ket structure by which economists measure all other market structures.Beginning in the 1700s with the father of economics, Adam Smith, manyeconomists have shown that the “invisible hand” of the perfectly compet-itive market is the best form of market structure.

2. The most important requirement of perfect competition is numerous buy-ers and sellers. When this assumption is met, any one firm’s output isminiscule compared to the market output. This condition is importantbecause it is one of the primary reasons why perfectly competitive firmsare price takers rather than price makers in the market.

3. A second important assumption of perfect competition is that of ahomogenous product where each firm’s output is indistinguishable fromany other firm’s output. The homogeneous product assumption meansthat every firm in the industry is selling exactly the same product, so thatthe only thing that firms can compete on is price, and not on other thingssuch as product design and product quality.

4. A third important assumption is that of free entry and exit. In order for thisfree entry condition to hold, there must be no barriers to entry.

5. Given a market structure of perfect competition, we can expect prices tobe set to a firm’s “marginal cost” of production (that is, P=MC). Moreover,this pricing scheme will be economically efficient, because the market isallocating resources efficiently and consumers will receive the most out-put at the best price.

Figure 10.5: Market Structure Forms

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1. What does the production function specify?

2. Define the short run. Define the long run.

3. What is the difference between fixed versus variable costs?

4. Explain the law of diminishing returns.

5. How can a knowledge of the supply side of the market help me in my per-sonal life?

6. Why do economists and politicians make such a big deal about the freemarket if there are few industries that are perfectly competitive?

7. The big buzz word in business today is “strategy.” Do economists and thelessons in this lecture have anything to say about just what “good” strate-gy is?

8. What does industry structure refer to? What are the major types of indus-try structures?

9. What is the central concept driving the structure-conduct-performance paradigm?

10. What is the relationship between the industry market price and the firm’smarginal revenue in a perfectly competitive industry?

1. Browse “Companies” for America’s largest private companies; can youidentify in which market structure the Top Ten companies are most likely tobe included? — www.forbes.com/lists

2. Search for “car rentals”; now choose any travel Web company (not a carrental company) and search for prices for a weekend trip to any city nearyou; can you find any substantial difference in prices? How about productdifferentiation? — www.google.com

McConnell, Campbell R., and Stanley L. Brue. Chapters 22 and 23.Economics: Principles, Problems, and Policies. 16th ed. New York:McGraw-Hill, 2005.

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LECTURE OBJECTIVES

1. Resume the discussion about the four different types of marketstructure: perfect competition, monopoly, oligopoly, and monop-olistic competition.

2. Learn about the various strategies and tactics that businessexecutives use to make big profits in the market place—often atthe expense of consumers.

3. Focus on the differences between monopolistic competition andoligopoly, and monopolistic competition and perfect competition.

Monopoly

1. In a monopoly, there is only one seller inthe market selling a product, and thatmonopolist sells a product for whichthere are no close substitutes. In such acase, the monopolist is a price maker andwields this power by controlling the quantitysupplied in the market.

2. The monopolist sets price equal to its marginal revenue, where marginalrevenue is the amount of revenue obtained by selling the last unit.Marginal revenue is higher than marginal cost, and their difference is themonopolist’s profits. The result is that consumers pay a lot more for a lotless in a monopolized market—while the monopolist earns profits wellabove that of the perfect competitor. Therefore, the government typicallyregulates monopolies and sets the prices that monopolists can charge.

3. Perfect competition and monopoly are actually more the exceptions,rather than the rule, in most global economies. Indeed, most industriesfall somewhere between these two extremes and can be classified byone of the two other forms of market structure—monopolistic competitionand oligopoly.

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Monopolistic Competition

The defining characteristics of monopolistic competition are a relativelylarge number of sellers; easy entry to, and exit from, the industry; andproduct differentiation.

Oligopoly vs. Monopolistic Competition

1. A monopolistically competitive industry is relatively unconcentrated. Incontrast, market concentration and price-making power are relatively highin an oligopoly.

2. The key concept of market concentration is important because thelevel of concentration serves as an indicator of the degree of what’scalled “strategic interaction” that might occur in an industry. Strategicinteraction describes how each firm’s business strategy depends on itsrivals’ strategies.

3. In the economics of strategy, the so-called “mutual interdependence rec-ognized” means that the executives of each firm are more likely to wantto collude when setting prices and quantities. Such collusion or collusivebehavior may be defined as the concerted action by executives in an oli-gopoly-like situation to restrict output and fix prices.

4. The most important distinction between oligopoly and monopolistic com-petition relies on the concept of collusion: on the one hand, because

of the small number of firms in an oligopoly, collusion is possi-ble; on the other hand, however, the relatively large numberof firms in a monopolistically competitive industry ensuresthat collusion is all but impossible.

Monopolistic Competition vs. Perfect Competition

1. Monopolistic competition resembles perfect compe-tition in three ways: there are numerous buyers andsellers, entry and exit are easy, and firms are pricetakers. The big difference is that with monopolisticcompetition, there is product differentiation.

2. Consumers have reasons other than price to prefer oneproduct over another because of product differentiation.In turn, the economic rivalry between firms will typicallytake the form less of price competition and more of whatis called non-price competition.

3. From the business executive’s perspective, product differen-tiation in general and advertising in particular have twostrategic goals in mind. The first goal is to increase con-sumer demand and thereby shift the firm’s demand curveoutwards and increase the firm’s market share. The secondgoal is to increase the inelasticity of the demand curve for itsproduct and thereby increase the pricing power of the firmand its ability to raise prices to increase its total revenuesand profits.

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Oligopoly

Oligopoly exists when a small number of typically large firms dominate anindustry, and the central element of oligopoly is the strategic interactionsthat might arise through either explicit or tacit collusion over price and out-put decisions, as well as decisions about both market entry and exit.

The Sources of Oligopoly

1. As with monopoly, one such source is the presence of economies ofscale in production. But in the case of oligopoly, it is not one firm butrather several large firms that win the race to achieve their minimum effi-cient scale and drive everyone else out.

2. Barriers to entry play an important role in creating and sustaining oligopo-listic industries. Such barriers to entry do indeed deter entry into an oli-gopolistic industry and thereby preserve the oligopolistic structure.Examples of those barriers are the so-called scale-economy barriers toentry, large capital requirements, and absolute-cost advantages derivedfrom valuable know-how in production or so-called trade secrets.

3. Market power signifies the degree of control that a firm or a small numberof firms has over the price and production decisions in an industry. Acommon measure of market power is the four-firm concentration ratio,which is simply defined as the percent of total industry output accountedfor by the four largest firms. (See Figure 11.1)

Industry Concentration in AmericaFour-firm

ConcentrationProduct Largest Firms Ratio

Instant breakfast Carnation, Pillsbury, Dean Foods 100Disposable diapers Procter & Gamble, Kimberly-Clark, Curity, Romar Tissue Mills 99Video game players Nintendo, Sega 98Cameras and film Eastman Kodak, Polaroid, Bell & Howell, Berkey Photo 98Telephones Western Electric, General Telephone, United Telecommunications,

Continental Telephone 95Car rentals Hertz, Avis, National, Budget 94Telephone service AT&T, MCI, Sprint 94(long distance)Batteries Duracell, Eveready, Ray-O-Vac, Kodak 94Soft Drinks Coca-Cola, Pepsico, Cadbury Schweppes (7-Up, Dr. Pepper,

A&W), Royal Crown 93Credit cards Visa, Mastercard, American Express 92Razor blades Gillette, Warner-Lambert (Schick, Wilkinson), Bic 91Greeting cards Hallmark, American Greetings, Gibson 91Toothpaste Procter & Gamble, Colgate-Palmolive, Lever Bros., Beecham 91Automobiles General Motors, Ford, Chrysler, Honda 90Beer Anheuser-Busch, Phillip-Morris (Miller), Coors, Stroh’s 90Canned tuna Heinz (Starkist), Unicord (Bumble Bee), Van Camp 82Spaghetti sauce Unilever (Ragu), Campbell Soup (Prego), Hunt-Wesson

(Health Choice) 80Aspirin Johnson & Johnson, Bristol-Meyers, American Home Products

Sterling Drug 78Records and tapes Time Warner, Sony, Thorn, Matsushita 77

Figure 11.1: Industry Concentration in America

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Cooperative vs. Non-cooperative Behavior

1. Concentration ratios are important in serving as an indicator of thedegree of strategic interaction and collusive behavior that might occur inan industry. Moreover, once this mutual interdependence is recognized,firms—and the business executives that run them—have a choicebetween pursuing cooperative versus non-cooperative behavior.

2. On the one hand, business executives act non-cooperatively when theyact on their own without any explicit or implicit agreements with otherfirms. That’s the kind of market conduct that typically characterizesmonopolistic competition.

3. On the other hand, business executives operate in a cooperative modewhen they try to minimize competition by explicitly or tacitly colluding onprice and output and other market issues. And that’s the kind of behaviorwe can fully expect from oligopolists in an industry.

The Cartel Model and Price Leadership

1. If the oligopolists can truly coordinate their activities, the obvious price toset is the same as that which would be set by a single monopolist, wheremarginal revenue equals marginal cost. Therefore, the oligopolists willjointly maximize their profits, which is why this model is often called thejoint profit maximization or cartel model.

2. In the price leadership model, the policing or enforcement mechanismused is often punishment by the price leader—usually the biggest ordominant firm in the industry. A practice evolves where the “dominantfirm”—usually the largest firm—initiates a price change and all other firmsmore or less automatically follow that price change. If one or more firmsrefuse to follow suit, the price leader may choose to back down.

Game Theory

1. The guiding philosophy ingame theory is that you willchoose your own strategyunder the assumption thatyour rival is analyzing yourstrategy and acting in hisor her own best interest.Understanding game theo-ry will therefore help youbetter understand not justyour own actions, but yourrivals’ actions.

2. A Nash Equilibrium in game theory—named after the Nobel Prize-winningmathematician John Nash—describes a situation in which no player canimprove his or her payoff given the other player’s strategy. The conceptof the Nash Equilibrium often describes a non-cooperative equilibrium. Inthe absence of collusion, each party chooses that strategy that is best foritself, without collusion and without regard for the welfare of society orany other party.

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1. Why is the OPEC oil cartel allowed to openly collude on price?

2. Can you summarize the major problems with monopoly, monopolisticcompetition, and oligopoly?

3. A lot of examples in the lectures were historical. Do practices like pricefixing still go on?

4. What is a cartel? Are cartels legal in the United States?

5. Explain the three key differences between oligopoly andmonopolistic competition.

6. Define the four-firm concentration ratio. Why are concentration ratios soimportant in studying market structure?

7. Discuss the concepts of strategic interaction and mutual interdependence.

8. From the economist’s point of view, product differentiation in general andadvertising in particular have what two goals?

9. Why are concentration ratios so important in the study of oligopoly?

10. What is the difference between explicit versus tacit collusion? Which oneis illegal in the United States?

11. What is a Nash Equilibrium? Why is this concept important?

1. Choose “Newsroom,” then “Reports,” and search for documents that con-tain the word “monopoly”; you will find many documents, so use theadvanced search option and look for Intel and Microsoft cases: Are thesecompanies “popular” in your final search? — www.ftc.gov

2. Learn more about oligopolies and real life applications —http://www.oligopolywatch.com

Caves, Richard. American Industry: Structure, Conduct, Performance. NewYork: Prentice-Hall, 1992.

McConnell, Campbell R., and Stanley L. Brue. Chapters 24, 25, 26, and 32.Economics: Principles, Problems, and Policies. 16th ed. New York:McGraw-Hill, 2005.

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Private vs. Public Goods

1. Private goods are divisible,coming in small enough unitsto be afforded by individualbuyers. Moreover, a privategood is also rival in consump-tion—if I consume the good,you cannot. Finally, a privategood is subject to the exclu-sion principle—those unableor unwilling to pay canbe excluded from theproduct’s benefits.

2. In contrast, public goods areindivisible, non-rival in con-sumption, and the exclusionfrom the consumption of apublic good is very difficultand, with some goods, evenimpossible. Hence, this non-excludability makes it difficult for the privatemarketplace to supply the good.

3. The economic difference between public goods and private goods restson technical considerations, not political philosophy. The central questionis whether we have the technical capability to exclude non-payers fromnon-rival goods like national defense or flood control (and if that exclu-sion is economically feasible).

Free Rider Problem

1. Once a public good is provided, a producer cannot possibly exclude non-payers from receiving its indivisible benefits. This creates a perverseincentive among potential buyers to want a free ride.

LECTURE OBJECTIVES

1. Focus on both how and why the government intervenes in theprivate marketplace.

2. Understand why such government intervention has an enormouseffect on our everyday lives.

3. Explore three very important types of market failures, publicgoods, externalities, and asymmetric information, and come tounderstand the role of government in correcting these types ofmarket failures.

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2. When the free-rider problem is present, potential buyers will not want topay for a good precisely because they can obtain that benefit for free.Furthermore, these free riders will not even want to reveal their true pref-erences as to how much they value the good.

3. The result of the free-rider problem is that the perceived demand for thepublic good doesn’t generate enough revenue to cover the costs of pro-duction, even though the collective benefits of the public good mayexceed the economic costs.

Benefit-Cost Analysis

1. The benefit-cost decision rule is simply this: if the benefits from the pro-ject exceed its costs, we should build the project. However, if the costsexceed the benefits, we should not. Note that benefit-cost analysis canindicate not just whether a public project is worth building, but also helpgovernment choose among the best competing alternatives.

2. Cost-benefit analysis helps shatter the simplistic notion that the best wayto make government more efficient is to always reduce governmentspending: efficient government does not necessarily mean minimizingpublic spending.

The Theory of Externalities

1. The idea behind externalities is that the production or consumption of agood may generate “spillover effects,” or external benefits or costs thatare not accurately reflected in the supply and demand curves of produc-ers and consumers. As a result of these spillover effects, or “externali-ties,” the free market may be inefficient and under-supply or over-supplythe good.

2. The externalities problem provides a strong economic rationale for agood portion of federal, state, and local intervention into the free marketon issues ranging from environmental protection and traffic congestion toeducation and public health. This is because in the case of negativeexternalities like pollution and congestion, the free market is likely to pro-duce too much of the externality and too much of the good generatingthe externality. In contrast, with a positive externality, the market under-supplies the good and generates too few spillover benefits.

The Coase Theorem

1. The Coase Theorem was conceived by University of Chicagoprofessor and Nobel laureate RonaldCoase. Coase argued that negativeor positive externalities do notrequire government interventionwhere (1) property ownership isclearly defined, (2) the numberof people involved is small,and (3) bargaining costsare negligible.

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2. The Coase Theorem helps to illustrate that, at least in some situations,government intervention into the marketplace may not be necessary,because externalities can be solved through individual bargaining.

3. While the Coase Theorem reminds us that clearly defined property rightscan be a positive factor in remedying externalities, many negative exter-nalities involve large numbers of affected people, high bargaining costs,and community property such as air and water. Thus, it is appropriate forthe government to intervene.

Tort System and Direct Government Intervention

1. A second approach to internalizing externalities that has some limitedapplicability and that relies upon a legal framework of liability laws isknown as the wrongful act or “tort system.” The idea behind torts is thatthe person or corporation that produces the negative externality is legallyliable for any damages caused to other persons.

2. However, as with the Coase Theorem, this tort system has its limita-tions. For one thing, lawsuits are expensive, time-consuming, and haveuncertain outcomes, while major time delays in the court system arecommonplace. In addition,there is great uncertainty.

3. Moreover, many negativeexternalities do not involveprivate property, but ratherproperty held in common.This observation leads us todirect government intervention,which involves placing limits:for example, this “commandand control” approach hasdominated environmentalpublic policy in the UnitedStates for decades.

4. Note there is a second way that this same “command and control”result can be achieved: this method involves the use of so-called“Pigouvian taxes and subsidies” to tax negative externalities and sub-sidize positive externalities.

Asymmetric Information

1. The asymmetric information problem can arise particularly when buyersdon’t have complete information about a product.

2. Two other types of situations can arise associated with asymmetric infor-mation. One is called “adverse selection,” when the problem beginsbefore the transaction occurs. The other is known as “moral hazard,” andthe problem doesn’t arise until after the transaction is consummated.

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1. Contrast private versus public goods.

2. Describe the free-rider problem and provide several examples.

3. What is the idea behind externalities?

4. Explain the Coase Theorem and its implications for government interven-tion into the market.

5. What is the importance of assigning property rights in theCoase Theorem?

6. How might the Coase Theorem break down?

7. A second approach to internalizing externalities relies upon a legal frame-work of liability laws. Describe this framework.

8. Why does the government require motorcycle riders to wear helmets insome states?

9. Why does the United States provide free vaccines to children?

10. Cigarettes are taxed heavily by the government and smoking is banned inmany public places. Is this a moral judgment against smoking?

11. Why can’t consumers obtain a detailed map about where different cellphone companies have the best coverage in their network so they canmake a more informed decision when purchasing a cell phone plan?

1. The Coase Theorem is a pillar concept in economics —www.ideachannel.com/Coase.htm.

2. The US Environmental Protection Agency: Choose “Browse EPA Topics,”then “Economics” and go to the recommended pages —http://www.epa.gov

Coase, Ronald H. The Firm, the Market, and the Law. Chicago: University ofChicago Press, 1990.

Dixit, Avinash, and Barry J. Nalebuff. Thinking Strategically. New York: W.W.Norton & Co., 1993.

McConnell, Campbell R., and Stanley L. Brue. Chapter 30. Economics:Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.

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Public Choice Theory

1. Discussions aboutgovernment interven-tion into the market-place have focusedupon what’s called anormative theory ofgovernment. This kindof normative theory isone in which economicarguments for govern-ment intervention havebeen presented intothe free market so asto increase benefitsto society.

2. But in dispensing theirnormative prescrip-tions, economists are not starry-eyed about the government any morethan they are about the free market. We know that just as there are mar-ket failures, there are “government failures” in which government inter-vention leads to waste or a redistribution of income, not from the rich tothe poor, but the other way around. These important issues are thedomain of public choice theory.

Revealing Preferences Through Majority Voting

(See Figure 13.1)

1. Many of the decisions about our government are made collectively in theUnited States through a process that relies heavily on majorityvoting. Although this democratic process generally works well at

LECTURE OBJECTIVES

1. Introduce public choice theory, a branch of microeconomics andpolitical science that examines how the democratic politicalprocess leads to economic choices.

2. Look at the expenditure side of the government equation.

3. Explore several aspects of the principles of taxation, such as theimportant differences between progressive, proportional, andregressive taxes.

4. Introduce one of the most powerful tools in microeconomics,known as “tax incidence analysis.”

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revealing oursocial prefer-ences, it can alsoproduce bothinefficiencies andinconsistencies.

2. Majority votingmay produce eco-nomically ineffi-cient outcomes,because it fails toincorporate thestrength of thepreferences of theindividual voters.

Political Logrolling

The trading ofvotes to secure favorable outcomes on decisions that would otherwisebe bad ones can turn an inefficient outcome into an efficient one.This technique is called political logrolling. Note, however, that logroll-ing can either increase or diminish economic efficiency depending onthe circumstances.

Paradox of Voting

1. The so-called paradox of voting refers to a situation when society maynot be able to rank its preferences consistently through majority voting.

2. Note that the problem in the paradox of voting is not irrational prefer-ences but rather a flawed procedure for determining the preferences.Hence, under certain circumstances, majority voting fails to make consis-tent choices that reflect the community’s underlying preferences.

Median Voter Model

(See Figure 13.2)

1. The median votermodel helpsexplain the two-party system ofRepublicans andDemocrats inAmerican politics,as well as why wetypically electcandidates repre-senting thepolitical center.

Figure 13.1: Inefficient “No” Vote

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Figure 13.2: Median Voter Model

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2. The “median voter” is defined as the person holding the exact middleposition on any issue.

3. A two-party system of majority voting such as the one in the UnitedStates moves political outcomes to the political center. It is for this reasonthat we often observe political candidates taking very similar positions,essentially becoming what one political wag once called “Tweedledumand Tweedledee.”

Government Expenditures

1. Americans face three levels of government: federal, state, and local.

2. These three levels of government reflect a division of fiscal responsibili-ties in a system that political scientists refer to as fiscal federalism. Butnote that their boundaries are not always clear cut.

3. Under fiscal federalism, the federal government is responsible for activi-ties that concern the entire nation, such as providing for national defenseand conducting foreign affairs, while state and local government providepublic goods to state and local residents.

Principles of Taxation

1. The two main competing philosophiesfor organizing a tax system are thebenefits-received principle and theability-to-pay principle.

2. The benefits-received principle orbenefit principle holds that differentindividuals should be taxed in pro-portion to the benefits they receivefrom government programs. There aresome public goods financed on thisbenefit principle basis, such as gaso-line taxes or a bridge toll.

3. While the benefit principle wouldappear to have great appeal on thegrounds of fairness, difficulties immediately arise when an accurate andwidespread application is considered.

4. The ability-to-pay principle of taxation contrasts sharply with the benefitprinciple. Ability-to-pay taxation states that the amount of taxes peoplepay should relate to their income or wealth. The higher someone’s wealthor income, the more taxes that person should pay in both absolute andrelative terms.

5. Usually tax systems organized along the ability-to-pay principle are alsoredistributive, meaning that they raise funds from higher-income peopleto increase the incomes and consumption of poorer groups.

6. The underlying economic idea behind ability-to-pay is that each additionaldollar of income received by a household will yield smaller and smallerincrements of satisfaction or marginal utility. While this ability-to-pay argu-

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ment is appealing, problems of application exist just as they do with thebenefit principle.

Progressive, Proportional, and Regressive Taxes

1. A tax is progressive if its average rate increases as income increases.Such a tax claims not only a larger absolute amount, but also a largerfraction or percentage of income as income rises; and a progressive taxredistributes income from the richer to the poorer.

2. In contrast, a regressive tax has an average rate that declines as incomeincreases. Such a tax takes a smaller and smaller proportion of incomeas income increases and effectively redistributes income from the poorerto the richer.

3. A tax is proportional, or flat, when its average rate remains the same,regardless of the size of income.

Personal and Corporate Income Tax

1. While the federal personal income tax in the United States is progressive,the federal corporate income tax is essentially a flat-rate proportional tax.

2. However, some tax experts argue that at least part ofthe tax is “passed through,” or “shifted,” to consumersin the form of higher product prices. To the extent thatthis occurs, the tax is regressive.

Payroll Taxes

1. Payroll taxes are levied on wage earnings to pay forsocial insurance programs like Social Security,Medicare, unemployment compensation, and disabilityprograms. They consist of about 15 percent of all wageincome for incomes, while this tax is split betweenemployer and employee.

2. The payroll tax does have some regressive featuresbecause it exempts property income and is higher on low wages than onhigh wages.

Sales, Excise, and Property Taxes

1. A sales tax is a general tax on consumption. In contrast, an excise tax isa tax on selected goods such as alcohol or tobacco or gasoline.

2. Sales and excise taxes are clearly regressive: a sales tax is regressivebecause a larger portion of a poor person’s income is exposed to the taxthan is true for a rich person.

3. As for property taxes, most economists conclude that property taxes onbuildings are regressive for the same reasons as for sales taxes.

Tax Incidence Analysis

1. The notion of “who bears the burden of a tax” is the domain of a fascinat-ing branch of microeconomics called tax incidence analysis.

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2. Specifically, the ability of a company to pass on a sales tax to its cus-tomers depends on the price elasticity of demand for the product: forexample, a company is able to shift more of the tax burden on to con-sumers when the price for a product is relatively more inelastic.

The Efficiency Loss of a Tax

1. The government decides the kind of tax it should impose on any particu-lar good or service, thus affecting both the efficiency of any given tax inraising revenues without harming the economy as well as equity consid-erations as to whether or not the tax is fair.

2. There is a deadweight loss in most cases when the government imposesa tax on either production or consumption. By raising the cost of produc-tion to producers or the cost of consumption to consumers, the price ofthe product effectively rises and discourages production or consumptionof the good.

Ramsay Tax Rule

1. The “Ramsay tax rule” provides governments with the guidance theyneed to minimize the deadweight loss of any tax they apply.

2. The rule depends on the price elasticity of demand and states that thegovernment should levy the heaviest taxes on those inputs and outputsthat are most price-inelastic in supply or demand.

3. In fact, Ramsey taxes may constitute an important way of raisingrevenues with a minimum loss of economic efficiency. But note that aneconomically efficient tax is not always judged to be a fair tax in thepolitical arena.

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1. What does public choice theory examine?

2. The median voter model helps explain why presidential candidates inAmerica often sound similar by election day. What happens when viablethird-party candidates such as Ross Perot in the 1990s or Ralph Nader in2004 throw their hats into the ring?

3. Explain the benefits-received principle.

4. Explain the ability-to-pay principle.

5. Explain progressive, proportional, and regressive taxes.

6. Describe the personal income tax, the corporate income tax, payroll andsocial insurance taxes, sales and excise taxes, and property taxes.Comment on the progressivity, proportionality, or regressiveness of each.

7. Every few years, there is talk about a flat tax replacing our current incometax system. Is this a good idea?

8. What is a poll tax? Is it “fair”? Why or why not?

9. What’s a value-added tax, and isn’t this kind of tax used widely in Europe?

1. Internal Revenue Service: Go to “1040 Central” and choose “TaxpayerRights” to learn more about your rights as a taxpayer — www.irs.gov

2. Visit the European Union in the United States website; select “EU Law &Policy Overviews” and look for “Value Added Tax”; follow this link to learnmore about the European VAT — www.eurunion.org

McConnell, Campbell R., and Stanley L. Brue. Chapter 31. Economics:Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.

Websites to Visit

�Questions

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LECTUREFOURTEEN

Land and Rent

1. The essential feature of land is thatits quantity is fixed and completelyunresponsive to price.

2. Pure economic rent is the pricepaid for the use of land and othernatural resources that are com-pletely fixed in supply.

3. Rent is actually determined in themarket in terms of productivityand location.

4. Different acres of land vary greatly in productivity. These productivity dif-ferences stem primarily from differences in soil fertility and such climaticfactors as rainfall and temperature and, therefore, are reflected inresource demand and the associated rents.

5. Location is as important as productivity in explaining differences in landrent. Business renters will pay more for a unit of land that is strategicallylocated with respect to materials, labor, and customers than for a unit ofland that is remote from the markets.

Labor Market and Wage Determination

1. The demand for factors in general and for labor in particular is a deriveddemand, implying that factor resources usually do not directly satisfy con-sumer wants, but indirectly by producing goods and services.

2. The derived nature of resource demand implies that the strength of thedemand for a factor such as labor depends on two things: (1) the produc-tivity of the factor helping to create the product, and (2) the market priceof the product that the factor is helping to produce. In particular, if pro-ductivity increases, wages increase. By the same token, if the price of theproduct falls, wages fall as well.

3. There are a number of important influences on a worker’s productivity,

LECTURE OBJECTIVES

1. Examine so-called “factor pricing,” or how land, labor, and capi-tal are priced in the marketplace.

2. Understand the nature of capital markets and its enormousapplication to both personal and professional lives.

3. Explore the net present value (NPV) tool and its application ininvestment decisions.

Lecture 14:Land, Labor, and Capital:

How Our Rents, Wages, and Interest Rates Are Set

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but the most important are the amount of capital and natural resourcesthat a person has to work with, the state of the technology, and the quali-ty of the labor itself.

4. The supply of labor might affect wages. The three most important deter-minants of the labor supply are labor force participation, hours worked,and the rate of immigration.

5. One of the most dramatic developments in labor force participation overthe last half-century has been the sharp influx of women into the workforce. At the same time, labor force participation by older men has fallensharply, particularly for men over 65.

6. One of the most interesting analytical concepts in labor market economicsis associated with the backward-bending curve. The idea behind the back-ward-bending curve is that the higher the wage, the more people will bewilling to work, but only to a point at which people will actually work less.The reason is that at higher wages, workers can afford more leisure eventhough each extra hour of leisure costs more in wages foregone.

Wage Differentials

1. One reason to explain the often hefty wage differentials observed amongpeople in different occupations refers to what economists call compensat-ing differentials. Such compensating differentials measure the relativeattractiveness of jobs as well as the degree of risk.

2. A second explanation looks into the differences that people have in boththeir mental and physical capabilities.

3. Still a third explanation of wage differentials refers to the differentamounts that people invest in their own human capital, where humancapital refers to the stock of useful and valuable skills and knowledgethat are accumulated by people in the process of their educationand training.

4. Economists refer to the excess of these wages above those of the next-best available occupation as a pure economic rent or, more precisely, aquasi-rent.

The Capital Market

1. One of the most important tasks of an economy, business, or householdis to allocate its capital across different possible investments. The analy-sis of capital markets provides us with a framework for evaluating invest-ments in new capital over time.

2. We distinguish between real capital—the bricks and mortar andmachines—and financial capital—the stocks and bonds and other loan-able funds—used to finance real capital.

3. There are three major categories of real capital goods. The first is struc-tures such as factories and homes. The second is equipment, includingconsumer durable goods, such as automobiles, and producer durableequipment, such as machine tools and computers. The third category ofcapital goods is inventories and includes things like cars in dealers’ lots.

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LECTUREFOURTEEN

Interest Rates

1. The interest rate is the price paid for the use of loanable funds,where the term loanable funds is used to describe funds that are avail-able for borrowing.

2. In particular, the interest rate is the amount of money that must be paidfor the use of one dollar of loanable funds for a year.

3. Because it is paid in kind, interest is typically stated as a percentage ofthe amount of money borrowed rather than as an absolute amount.

The Rate of Return

The rate of return on capital is the additional revenue that a firm canearn from its employment of new capital. This additional revenue is usu-ally measured as a percentage rate per unit of time—the annual netreturn per dollar of invested capital.

Theory of Loanable Funds

1. The theory of loanable funds helps to better understand how the interac-tion of interest rates and rates of return actually determine investmentdecisions in a market economy.

2. Firms will demand loanable funds to invest in new projects so long as therate of return on capital is greater than or equal to the interest rate paidon funds borrowed.

Net Present Value (NPV)

(See Figure 14.1)

1. In most cases, capital investments that are made today and that we payfor today don’t really bear all of their fruits for many years. The net pre-sent value (NPV) concept is the tool that allows us to evaluate an invest-ment for which a capital outlay occurs today—say for a new factory orpiece of machinery—but for which the benefits from that investmentcome in the form of a revenue stream over many years.

2. On the one hand, the net present value rule says that if an investment isnegative, your company should not make the investment. On the otherhand, if the value of an investment in net present value terms is positive,or zero at the prevailing cost of borrowed funds, the rule says you shouldmake the investment.

Figure 14.1

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1. What is rent seeking? Provide an example from public policy.

2. How come houses that are run down and beat up sometimes sell foralmost as much as brand new houses in an upscale neighborhood?

3. Explain why the demand for labor and other factors of production is aderived demand.

4. The derived nature of resource demand implies that the strength of thedemand for a factor such as labor will depend on what two things?

5. What does human capital refer to?

6. A lot of people are getting wage increases, but at the same time theyare seeing their health care benefits cut. What does that say about thelabor market?

7. On a personal level, what kind of question can capital analysis help usto answer?

8. At a professional level, what kind of questions can capital analysis helpbusiness executives to answer?

9. Suppose the economy had been in a deep recession, but now is movingtoward full employment. What will happen to the interest rate and why?

1. Visit the Bureau of Labor Statistics and select “Wages, Earnings &Benefits”; you can explore for information on wages, earnings, and benefitsof workers categorized by geographical area, occupation, or industry —www.bls.gov

2. Click on “Economic Research and Data” and follow “Statistics: Releasesand Historical Data”; interest rates can be found under “Interest Rates”;check for the weekly release of the selected interest rates and follow thedirection rates are currently showing — www.federalreserve.gov

3. Select “Financial Calculators” under “Tools” and click on the new “NetPresent Value Calculator”; work on the example presented in this lesson tosee how the acceptance-rejection criteria differ depending on the selecteddiscount rate — www.investopedia.com

McConnell, Campbell R., and Stanley L. Brue. Chapters 27, 28, 29, and 35.Economics: Principles, Problems, and Policies. 16th ed. New York:McGraw-Hill, 2005.

Websites to Visit

�Questions

Suggested Reading

FOR GREATER UNDERSTANDING

COURSEMATERIALS

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COURSE MATERIALS

Suggested Reading for This Course:

You’ll get the most out of this course if you have the following book:

McConnell, Campbell R., and Stanley L. Brue. Economics: Principles,Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.

Suggested Readings for Lectures in This Course:

Caves, Richard. American Industry: Structure, Conduct, Performance. NewYork: Prentice-Hall, 1992.

Coase, Ronald H. The Firm, the Market, and the Law. Chicago: University ofChicago Press, 1990.

Dixit, Avinash, and Barry J. Nalebuff. Thinking Strategically. New York: W.W.Norton & Co., 1993.

Navarro, Peter. If It’s Raining in Brazil, Buy Starbucks. New York:McGraw-Hill, 2001.

Snowdon, Brian, Howard Vane, and Peter Wynarczyk. A Modern Guide toMacroeconomics: An Introduction to Competing Schools of Thought.Cheltenham, UK: Edward Elgar Publishers, 1995.

Solow, Robert, and John B. Taylor. Inflation, Unemployment, and MonetaryPolicy. Cambridge, MA: The MIT Press, 1999.

Woodward, Bob. Maestro: Greenspan’s Fed and the American Boom. NewYork: Simon & Schuster, 2000.

These books are available online through www.modernscholar.comor by calling Recorded Books at 1-800-636-3399.