Getting Started With Economics
Economics and the choices we make in regards to money. These are my notes from books I have read on the subject.
Table of Contents
Thinking About Money
One of the first things to think about in Economics is scarcity. Scarcity is when human wants are greater than the available supply of time, goods, and resources. The problems of scarcity and choice are basic economic problems faced by every society. Resources are the basic categories of inputs used to produce goods and services. Land is any natural resource provided by nature that is used to produce a good or service. Labor is the mental and physical capacity of workers to produce goods and services. Entrepreneurship is the creative ability of individuals to seek profits by taking risks and combining resources to produce innovative products.
Capital is a human-made good used to produce other goods and services. Money by itself does not produce goods and services. It is only a means to facilitate the purchase and sale of resources and consumer goods. Economics is therefore the study of how society chooses to allocate its scarce resources to the production of goods and services to satisfy unlimited wants. Macroeconomics is the branch of economics that studies decision making for the economy as a whole. Microeconomics is the branch that studies decision making by a single individual, household, firm, industry, or level of government.
A model is a simplified description of reality used to understand and predict the relationship between variables. Ceteris paribus is a Latin phrase that means while certain things change, all other things remain unchanged. A theory cannot be tested legitimately unless its ceteris paribus assumption is satisfied. The fact that one event follows another does not necessarily mean that the first event caused the second event.
Positive economics is an analysis limited to statements that are verifiable. Economists’ forecasts can differ because using the same methodology, economists can agree that event X causes event Y, but disagree over the assumption that event X will occur. Normative economics is an analysis based on subjective value judgements. When opinions or points of view are not based on facts, they are scientifically untestable.
A direct relationship is a positive association between two variables. When one variable increases, the other variable increases. Also, when one variable decreases, the other variable decreases. An inverse relationship is a negative association between two variables. When one variable decreases, the other also decreases. The slope of a graph is the ratio of the change in the variable on the vertical axis to the change in the variable on the horizontal axis. An independent relationship means a zero association between two variables. When one variable changes, the other variable remains unchanged.
A shift in a curve occurs only when the ceteris paribus assumption is relaxed and a third variable not shown on either axis of the graph is allowed to change.
Production Possibilities
The opportunity cost is the best alternative sacrificed for a chosen alternative. Marginal analysis is an examination of the effects of additions or subtractions from a current situation. The production possibilities curve shows the maximum combinations of two outputs an economy can produce in a given period of time with its available resources and technology.
Technology is the body of knowledge applied to how goods are produced. Scarcity limits an economy to points on or below its production possibilities curve. The production possibilities curve consists of all efficient output combinations at which an economy can produce more of one good only by producing less of the other good.
The law of increasing opportunity costs is the principle that the opportunity cost increases as production of one output expands. Because resources are not equally well -suited to producing all products, it is common to experience increasing opportunity costs and a bowed-out production possibilities curve. Economic growth is the ability of an economy to produce greater levels of output, represented by an outward shift of its production possibilities curve.
An investment is the accumulation of capital, such as factories, machines, and inventories, used to produce goods and services. A nation can accelerate economic growth by increasing its production of capital goods in excess of the capital being worn out in the production process.
Demand and Supply
The law of demand is the principle that there is an inverse relationship between the price of a good and the quantity buyers are willing to purchase in a defined time period. A demand curve shows the various quantities of product consumers are willing to purchase at possible prices during a specified period of time.
A change in quantity demanded is a movement between points along a stationary demand curve. The change in demand is an increase or decrease in the quantity demanded at each possible price. An increase in demand is a rightward shift in the entire demand curve. A decrease in demand is a leftward shift in the entire demand curve. Under the law of demand, any decrease in price along the vertical axis will cause an increase in quantity demanded, measured along the horizontal axis, and appears as a movement along the demand curve. Changes in non-price determinants can produce only a shift in the demand curve and not a movement along the demand curve.
A normal good is any good for which there is a direct relationship between changes in income and its demand curve. An inferior good is any good for which there is an inverse relationship between changes in income and its demand curve. A substitute good is one that competes with another good for consumer purchases. As a result, there is a direct relationship between a price change for one good and the demand for its competitor good. The complementary good is a good that is jointly consumed with another good. As a result, there is an inverse relationship between a price change for one good and the demand for its “go together” good.
The law of supply is the principle that there is a direct relationship between the price of a good and the quantity sellers are willing to offer for sale in a defined time period. The supply curve shows the various quantities of a product sellers are willing to produce and offer for sale at possible prices during a specified time period. Only at a higher price will it be profitable for sellers to incur the higher opportunity cost associated with producing and supplying a larger quantity.
The change in quantity supplied is a movement between points along a stationary supply curve. Under the law of supply, any increase in price along the vertical axis will cause an increase in the quantity supplied, measured along the horizontal axis, and appears as a movement along the supply curve. A change in supply is an increase or decrease in the quantity supplied at each possible price. An increase in supply is a rightward shift in the entire supply curve. A decrease in supply is a leftward shift in the entire supply curve. Changes in non-price determinants can produce only a shift in the supply curve and not a movement along the supply curve.
A market is any arrangement in which buyers and sellers interact to determine the price and quantity of goods and services exchanged. A surplus is a market condition existing at any price where the quantity supplied is greater than the quantity demanded. A shortage is a market condition existing at any price where the quantity supplied is less than the quantity demanded.
The equilibrium is a market condition that occurs at any price and quantity at which the quantity demanded and the quantity supplied are equal. Graphically, the intersection of the supply curve and the demand curve is the market equilibrium price-quantity point. When all other non-price factors are held constant, this is the only stable coordinate on the graph. A price system is a mechanism that uses the forces of supply and demand to create an equilibrium through rising and falling prices.
The Markets
The price ceiling in a market is a legally established maximum price a seller can charge. Conversely, a price floor is a legally established minimum price a seller can be paid. A price ceiling or price floor prevents market adjustment in which competition among buyers and sellers bids the price upward or downward to the equilibrium price. A market failure in which market equilibrium results in too few or too many resources being used in the production of a good or service. This inefficiency may justify government intervention.
An externality is a cost or benefit imposed on people other than the consumers and producers of a good or service. When the supply curve fails to include external costs, the equilibrium price is artificially low, and the equilibrium quantity is artificially high. External costs cause the market to overallocate resources. Then, when the demand curve fails to include external benefits the equilibrium price is artificially low, and the equilibrium quantity is artificially low. External benefits cause the market to underallocate resources. A public good has two properties. Users collectively consume benefits and there is no way to bar people who do not pay from consuming the good or service.
If public goods are available only in the marketplace, people wait for someone else to pay, and the result is an underproduction or zero production of public goods.
Price Elasticity of Demand
Price elasticity of demand is the ratio of the percentage change in the quantity demanded of a product to a percentage change in its price. Elastic demand is a condition in which the percentage change in quantity demanded is greater than the percentage change in price.
The total revenue is the number of dollars a firm earns from the sale of a good or service, which is equal to its price multiplied by the quantity demanded.
Inelastic demand is a condition in which the percentage change in quantity demanded is less than the percentage change in price. Unitary elastic demand is a condition in which the percentage change in quantity demanded is equal to the percentage change in price. Perfectly elastic demand is a condition in which a small percentage change in price brings about an infinite percentage change in quantity demanded.
Perfectly inelastic demand is a condition in which the quantity demanded does not change as the price changes. The price elasticity coefficient of demand applies only to a specific range of prices.
The price elasticity coefficient of demand is directly related to the availability of suitable substitutes for a product. The price elasticity coefficient of demand is directly related to the percentage of one’s budget spent for a good or service. In general, the price elasticity coefficient of demand is higher the longer a price change persists.
If the demand curve slopes downward and the supply curve slopes upward, sellers cannot raise the price by the full amount of the tax. In the case where demand is perfectly inelastic, sellers can raise the price by the full amount of a tax.
Production Costs
Explicit costs are payments to nonowners of a firm for their resources. Implicit costs are the opportunity costs of using resources owned by a firm. Economic profit is total revenue minus explicit and implicit costs.
Normal profit is the minimum profit necessary to keep a firm in operation. A firm that earns normal profits earns total revenue equal to its total opportunity cost. Since business decision making is based on economic profit, rather than accounting profit, the word profit always means economic profit.
Fixed input is any resource for which the quantity cannot change during the period of time under consideration. A variable input is any resource for which the quantity can change during the time under consideration. A short run is a period of time so short that there is at least one fixed input. A long run is a period of time so long that all inputs are variable. The production function is the relationship between the maximum amounts of output a firm can produce and various quantities of inputs. A marginal product is the change in total output produced by adding one unit of a variable input, with all other inputs used being held constant.
The law of diminishing returns is the principle that beyond some point the marginal product decreases as additional units of a variable factor are added to a fixed factor. The total fixed cost is a cost that does not vary as output varies and that must be paid even if output is zero. These are payments that the firm must make in the short run, regardless of the level of output. The total variable cost is the cost that is zero when output is zero and varies as output varies. The total cost is the sum of total fixed cost and total variable cost at each level of output.
The average fixed cost is the total fixed cost divided by the quantity of output produced. The average variable cost is the total variable cost divided by the quantity of output produced. The average total cost is the total cost divided by the quantity divided by the quantity of output produced. The marginal cost is the change in total cost when one additional unit of output is produced.
The marginal average rule is the rule that states when marginal cost is below average cost, average cost falls. When marginal cost is above average cost, average cost rises. When marginal cost equals average cost, average cost is at its minimum point. A firm operates in the short run when there is insufficient time to alter some fixed input. The firm plans in the long run when all inputs are variable.
The long run average cost curve traces the lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size. Economies at scale is a situation in which the long run average cost curve declines as the firm increases output. The constant returns to scale is a situation in which the long run average cost curve does not change as the firm increases output. Diseconomies of scale is a situation in which the long run average cost curve rises as the firm increases output.
Economic profit is equal to total revenue minus both explicit and implicit costs. Explicit costs are payments to nonowners of a firm for their resources. Implicit costs are the opportunity costs of forgone returns to resources owned by a firm. Economic profit is total revenue minus explicit and implicit costs. Economic profit can be positive, zero, or negative. Economic profit is important for decision making purposes because it includes implicit costs and accounting profit does not. Accounting profit equals total revenue minus explicit costs.
Normal profit is the minimum profit necessary to keep a firm in operation. A normal profit is a zero economic profit, and it signifies there is just enough total revenue to pay the owners for all explicit and implicit costs.
A fixed input is any resource for which the quantity cannot change during the period of time under consideration. A variable input is any resource for which the quantity can change during the period of time under consideration.
The short run is a time period during which a firm has at least one fixed input, such as its factory size. The long run for a firm is defined as a period during which all inputs are variable.
A production function is the relationship between output and inputs. Holding all other factors of production constant, the production function shows the total output as the amount of one input, such as labor, varies.
Marginal product is the change in total output caused by a one unit change in a variable input, such as the number of workers hired. The law of diminishing returns states that after some level of output in the short run, each additional unit of the variable input yields a smaller and smaller marginal product. This range of declining marginal products is the region of diminishing returns.
Total fixed cost consists of costs that do not vary with the level of output, such as rent for office space. Total fixed cost is the cost of inputs that do not change as a firm changes output in the short run. Total variable cost consists of costs that vary with the level of output, such as wages. Total cost is the sum of total fixed cost and total variable cost.
Marginal cost is the change in total cost associated with one additional unit of output. Average fixed cost is the total fixed cost divided by total output. Average variable cost is the total variable cost divided by total output. Average total cost is the total cost divided by output, or the sum of average fixed cost and average variable cost.
The marginal-average rule explains the relationship between marginal cost and average cost. When marginal cost is less than average cost, average cost falls. When marginal cost is greater than average cost, average cost rises. Following this rule, the marginal cost curve intersects the average variable cost curve and the average total cost curve at their minimum points.
The long-run average cost curve is a curve drawn tangent to all possible short run average total cost curves. When it decreases as output increases, a firm experiences economies at scale. If it remains unchanged as output increases, a firm experiences constant returns to scale. If the curve increases as output increases, a firm experiences diseconomies at scale.
Since business decision making is based on economic profit, rather than accounting profit, the work profit in this text always means economic profit. A firm operates in the short run when there is insufficient time to alter some fixed input. The firm plans in the long run when all inputs are variable. The plant size selected by a firm in the long run depends on the expected level of production.
Perfect Competition
The market structure is a classification system for the key traits of a market, including the number of firms, the similarity of products they sell, and the ease of entry into and exit from the market. Perfect competition is a market structure characterized by a large number of small firms, a homogeneous product, and very easy entry into or exit from the market. Perfect competition is also called pure competition. The large number of sellers' conditions is met when each firm is so small relative to the total market that no single firm can influence the market price.
A homogeneous product is a good or service that is identical regardless of which firm produces it. If a product is homogeneous, buyers are indifferent as to which seller’s product they buy. A barrier to entry is any obstacle that makes it difficult for a new firm to enter a market. Perfect competition requires that resources be completely mobile to freely enter or exit a market. A price taker is a seller that has no control over the price of the product it sells.
Marginal revenue is the change in total revenue from the sale of one additional unit of output. In perfect competition, the firm’s marginal revenue equals the price, which the firm views as a horizontal demand curve. In perfect competition, the firm maximizes profit or minimizes loss by producing the output where marginal revenue equals marginal cost. The firm will shut down when the price drops below the minimum average variable cost.
A perfectly competitive firm’s short run supply curve is a firm’s marginal cost curve above the minimum point on its average variable cost curve. The perfectly competitive industry’s short run supply curve is the supply curve derived from horizontal summation of the marginal cost curves of all firms in the industry above the minimum point of each firm’s average variable cost curve.
A perfectly competitive industry’s long run supply curve is the curve that shows the quantities supplied by the industry at different equilibrium prices after firms complete their entry and exit. A constant cost industry is an industry in which the expansion of industry output by the entry of new firms has no effect on the individual firm’s average total cost curve. The long run supply curve in a perfectly competitive constant cost industry is perfectly elastic and drawn as a horizontal line.
Market structure consists of three market characteristics; number of sellers, nature of the product, and ease of entry into the market.
Perfect competition is a market structure in which an individual firm cannot affect the price of the product it produces. Each firm in the industry is very small relative to the market as a whole, all the firms sell a homogenous product, and firms are free to enter and exit the industry.
A homogenous product is a good or service that is identical regardless of which firm produces it.
A price taker firm in perfect competition faces a perfectly elastic demand curve. It can sell all it wishes at the market determined price, but it will sell nothing above the given market price. This is because so many competitive firms are willing to sell the same product at the going market price.
The total revenue total cost method is one way a firm determines the level of output that maximizes profit. Profit reaches a maximum when the vertical difference between the total revenue and the total cost curve is a maximum.
The marginal revenue equals marginal cost method is a second approach to finding where a firm maximizes profits. Marginal revenue is the change in total revenue from a one unit change in output. Marginal revenue for a perfectly competitive firm equals the market price. The mr=mc rule states that the firm maximizes profit or minimizes loss by producing the output where marginal revenue equals marginal cost. If the price is below the minimum point on the average variable cost curve, the mr=mc rule does not apply, and the firm shuts down to minimize its losses.
The perfectly competitive firm’s short-run supply curve is a curve showing the relationship between the price of a product and the quantity supplied in the short run. The individual firm always produces along its marginal cost curve above its intersection with the average variable cost curve. The perfectly competitive industry’s short-run supply curve is the horizontal summation of the short-run supply curves of all the firms in the industry.
Long run perfectly competitive equilibrium occurs when a firm earns a normal profit by producing where price equals the minimum long-run average cost, the minimum short-run average, and the short-run marginal cost.
In a constant-cost industry, total output can be expanded without an increase in the individual firm’s average total cost. Because input prices remain constant, the long-run supply curve in a constant-cost industry is perfectly elastic.
The large number of sellers' conditions is met when each firm is so small relative to the total market that no single firm can influence the market price. If a product is homogenous, buyers are indifferent as to which seller’s product they buy. Perfect competition requires resources to be completely mobile to freely enter or exit a market. In perfect competition, the firms’ marginal revenue equals the prices, which the firm views as a horizontal demand curve.
In perfect competition, the firm maximizes profit or minimizes losses by producing the output where marginal revenue equals marginal cost. The firm will shut down when the price drops below the minimum average variable cost. The long-run supply curve is a perfectly competitive constant-cost industry that is perfectly elastic and drawn as a horizontal line.
Monopoly
A monopoly is a market structure characterized by a single seller, unique product, and impossible entry into the market. A natural monopoly is an industry in which the long run average cost of production declines throughout the entire market. As a result, a single firm can supply the entire market demand at a lower cost than two or more smaller firms. A network good is one that increases in value to each user as the total number of users increases. As a result, a firm can achieve economies of scale.
Because of economies of scale, a single firm in an industry can produce enough output to satisfy market demand and produce this output at a lower per unit cost than would be possible if the market was served by more than one firm. As the number of people connected to a network goods system increases, the greater the benefits each person receives from being in the network. A price maker is a firm that faces a downward sloping demand curve and therefore it can choose among the price and output combinations along the demand curve.
The demand and marginal revenue curves of the monopolist are downward sloping. In contrast to the horizontal demand and corresponding marginal revenue curves facing the perfectly competitive firm. The marginal revenue curve for a straight line demand curve intersects the quantity axis halfway between the origin and the quantity axis intercept of the demand curve. The monopolist always maximizes profit by producing at a price on the elastic segment of its demand curve.
If the positions of a monopolist’s demand and cost curves give it a profit and nothing disturbs these curves, the monopolist will earn profit in the long run. Price descrimination is the practice of a seller charging different prices for the same product that are not justified by cost differences. Arbitrage is the practice of earning a profit by buying a good at a low price and reselling the good at a higher price.
A monopolist is characterized by inefficiency because resources are underallocated to the production of its product. Monopoly harms consumers on two fronts. The monopolist charges a higher price and produces a lower output that would result under a perfectly competitive market structure.
Monopoly is a single seller that faces the entire industry demand curve because it is the only seller. The monopolist sells a unique product, and extremely high barriers to entry protect it from competition.
Barriers to entry that prevent new firms from entering an industry are: ownership of an essential resource, legal barriers, and economies of scale. Government franchises, licenses, patents, and copyrights are the most obvious legal barriers to entry.
A natural monopoly arises because of the existence of economies of scale in which the long-run average cost curve falls over the full range of output demanded in the market. Economies of scale allow a single firm, rather than several firms, to produce enough output to satisfy the entire market demand at the lowest possible cost. Whichever firm expands first gains a cost advantage and monopoly status, as smaller firms leave the industry because of their high costs.
A network good is a good that increases in value to each user as the total number of users increases. A price maker firm faces a downward sloping demand curve. It therefore searches its demand curve to find the price-output combination that maximizes its profit or minimizes its losses. The marginal revenue and demand curves are downward sloping for a monopolist. The marginal revenue curve for a monopolist lies below the demand curve, and the total revenue curve reaches its maximum where marginal revenue equals zero.
Price elasticity of demand corresponds to sections of the marginal revenue curve. When MR is positive, price elasticity of demand is elastic. When MR is equal to zero, price elasticity of demand is unit elastic. When MR equal is negative, price elasticity of demand is inelastic.
The short run profit maximizing monopolist, like the perfectly competitive firm, locates the profit maximizing price by producing the output where the MR and MC curves intersect. If this price is greater than the average total cost, the firm earns an economic profit. If the price is less than average total cost but greater than average variable cost, the firm loses money but remains in business. Finally, if the price is less than the average variable cost, the monopolist shuts down to minimize losses.
The long run profit maximizing monopolist earns a profit because of barriers to entry. If demand is low and costs or high, thus creating the prospect of long run losses, the monopolist will leave the industry.
Price descrimination allows the monopolist to increase profits by charging buyers different prices rather than a single price. Three conditions are necessary for price descrimination: the seller possesses some price setting ability, buyers in different markets must have different price elasticities of demand, and buyers must be prevented from reselling the product at a higher price than the purchase price.
Monopoly disadvantages include the following: a monopolist charges a higher price and produces less output than a perfectly competitive firm. Resource allocation is inefficient because the monopolist produces less than if competition existed. Monopoly produces higher long run profits than if competition existed. Monopoly transfers income from consumers to producers to a greater degree than under perfect competition.
Because of economies of scale, a single firm in an industry will produce output at a lower pre-unit cost than two or more firms.
As the number of people connected to a network goods system increases, the greater the benefit each person receives from the network goods. The demand and marginal revenue curves of the monopolist are downward sloping in contrast to the horizontal demand and corresponding marginal revenue curves facing the perfectly competitive firm. The marginal revenue curve for a straight line demand curve intersects the quantity axis halfway between the origin and the quantity axis intercept of the demand curve. The monopolist always maximizes profit by producing at a price on the elastic segment of its demand curve.
If the positions of a monopolist’s demand and cost curves give it a profit and nothing disturbs these curves, the monopolist will earn profit in the long run. A monopolist is characterized by inefficiency because resources are under allocated to the production of its product. Monopoly harms consumers on two fronts. The monopolist charges a higher price and produces a lower output than would result under a perfectly competitive market structure.
Monopolistic Competition and Oligopoly
Monopolistic competition is a market structure characterized by many small sellers, a differentiated product, and easy market entry or exit. The many-sellers condition is met when each firm is so small relative to the total market that its pricing decisions have a negligible effect on the market price. Product differentiation is the process of creating real or apparent differences between goods and services. A firm can charge higher prices if it makes its products seem unique. Nonprice competition is the situation in which a firm competes using advertising, packaging, product development, better quality, and better service, rather than low prices.
The demand curve for a monopolistically competitive firm is less elastic, or steeper, than for a perfectly competitive firm and more elastic, or flatter, than for a monopolist. Oligopoly is a market structure characterized by few large sellers, either a homogenous or a differentiated product, and difficult market entry. Mutual interdependence is a condition in which an action by one firm may cause a reaction from other firms. The few-sellers condition is met when these few firms are so large relative to the total market that they can affect the market price. Buyers in an oligopoly may or may not be indifferent as to which seller’s product they buy.
Price leadership is a pricing strategy in which a dominant firm sets the price for an industry and the other firms follow. A cartel is a group of firms that formally agree to reduce competition by coordinating the price and output of a product. Game theory is a model of the strategic moves and countermoves of rivals. The payoff matrix demonstrates why a competitive oligopoly tends to result in both rivals using a low-price strategy that does not maximize mutual profits. As long as the benefits exceed the costs, cheating can threaten formal or informal agreements among oligopolists to maximize joint profits.
Monopolistic competition is a market structure characterized by many small sellers, a differentiated product, and easy entry or exit from the market. Given these characteristics, firms in monopolistic competition have a negligible effect on the market price.
Product differentiation is a key characteristic of monopolistic competition. It is the process of creating real or apparent differences between products.
Nonprice competition includes advertising, packaging, product development, better quality, and better service. Under monopolistic competition and oligopoly, firms may compete using nonprice competition, rather than price competition.
Short run equilibrium for a monopolistic competitor can yield economic losses, zero economic profits, or economic profits. In the long run, monopolistic competitors make zero economic profits.
Comparing monopolistic competition with perfect competition, we find that in the long run the monopolistically competitive firm does not achieve allocative efficiency, charges a higher price, restricts output, and does not produce where average costs are at a minimum.
Oligopoly is a market structure characterized by few sellers, homogeneous or differentiated products, and difficult market entry. Oligopolies are mutually interdependent because an action by one firm may cause a reaction from other firms.
The nonprice competition model is a theory that might explain oligopolistic behavior. Under this theory, firms use advertising and product differentiation, rather than precise reductions, to compete.
Price leadership is another theory of pricing behavior under oligopoly. When a dominant firm in an industry raises or lowers its price, other firms follow suit.
A cartel is a formal agreement among firms to set prices and output quotas. The goal is to maximize joint profits, but firms have an incentive to cheat, which is a constant threat to a cartel.
Game theory reveals that oligopolies are mutually interdependent in their pricing policies, without collusion, oligopoly prices and mutual profits are lower, and oligopolists have a temptation to cheat on any collusive agreement.
Comparing oligopoly with perfect competition, we find that the oligopolist allocates resources inefficiently, charges a higher price, and restricts output so that price may exceed average cost enabling long run profits.
The many sellers’ condition is met when each firm is so small relative to the total market that its pricing decisions have a negligible effect on the market price.
A firm can charge higher prices if it makes its products seem unique.
The demand curve for a monopolistically competitive firm is less elastic than for a perfectly competitive firm and more elastic than for a monopolist.
The few-sellers condition is met when these few firms are so large relative to the total market that they can affect the market price.
Buyers in an oligopoly may or may not be indifferent as to which seller’s product they buy.
The payoff matrix demonstrates why a competitive oligopoly tends to result in both rivals using a low price strategy that does not maximize mutual profits.
As long as the benefits exceed the costs, cheating can threaten formal or informal agreements among oligopolists to maximize joint profits.
GDP
Gross domestic product is the market value of all final goods and services produced in a nation during a period of time.
This is the most reported measurement of an economy. GDP includes only current transactions, meaning final sales. It does not count purely private or public financial transactions.
A transfer payment is a government payment to individuals not in exchange for goods or services currently produced.
GDP only counts final goods that are sold or produced. Final goods are finished goods or services produced for the ultimate user. Intermediate goods are goods and services used as inputs for the production of final goods.
The circular flow model shows the exchange of money, products, and resources between households and businesses. The upper half represents product markets, in which households exchange money for goods and services produced by firms. The bottom half of the diagram represents the factor markets, in which firms demand the natural resources, labor, capital, and entrepreneurship needed to produce the goods and services sold in the product markets.
Expenditure approach is the national income accounting method that measures GDP by adding all the spending for final goods during a period of time. This includes
- C - personal consumption
- I - investment
- G- government spending
- (X-M) - net exports
- Formula for GDP = C+ I + G + (X-M)
Because GDP only counts market transactions, it excludes activities that are unpaid like child rearing. GDP is blind to whether a small fraction of the population consumes most of a country’s GDP or consumption is evenly divided. GDP is a quantitative, rather than a qualitative measure of the output of goods and services. GDP does not directly measure quality of life variables such as leisure time.
It can be argued that GDP understates national well being because no allowance is made for variables such as leisure time, life expectancy, and other such things.
Underground activities are not counted for GDP because there are no transaction records. If the underground economy is sizable, GDP will understate an economy’s performance by a sizable amount. Since the costs of negative by-products are not deducted, GDP overstates the national well-being.
So far, GDP has been expressed as nominal GDP. Nominal GDP is the value of all final goods based on the prices existing during the time period of production. This adjusted GDP allows meaningful comparison over time when prices are changing.
Measuring the difference between changes in output and changes in the price level involves making an important distinction between nominal GDP and real GDP. Real GDP is the value of all final goods produced during a given time period based on the prices existing in selected base year. GDP chain price index is a measure that compares changes in the prices of all final goods during a given year relative to the prices of those goods in a base year. This index is also called GDP price index or simply GDP deflator.
Business and Unemployment
The business cycle is alternating periods of economic growth and contraction. These changes are measured in real GDP. The peak is the phase of the business cycle in which real GDP reaches its maximum after rising during a recovery. A recession is the downturn in the business cycle during which GDP declines and the unemployment rate rises. It is also called a contraction.
The trough is the phase of the business cycle in which real GDP reaches its minimum after falling during a recession. An expansion is an upturn in the business cycle during which real GDP rises. This is also known as a recovery. Economic growth is an expansion in national output measured by the annual percentage increase in a nation’s real GDP.
We value economic growth as one of our nation’s economic goals because it increases our standard of living. Leading indicators are variables that change before real GDP changes. Coincident indicators are variables that change at the same time that real GDP changes. Lagging indicators are variables that change after real GDP changes.
Unemployment rate is the percentage of people in the civilian labor force who are without jobs and are actively seeking jobs. The civilian labor force is the number of people 16 years or older who are employed or who are actively seeking a job, excluding armed forces, homemakers, discouraged workers, and other persons not in the labor force.
A discouraged worker is a person who wants to work but has given up searching for work because they believe there will be no job offers. Frictional unemployment is temporary unemployment caused by the time required of workers to move from one job to another. Structural unemployment is caused by a mismatch of skills of workers out of work and the skills required for existing job opportunities.
Outsourcing is the practice of a company having its work done by another company in another country. Offshoring is the practice of work for a company being performed by the company’s employees located in another country.
Cyclical unemployment is caused by the lack of jobs during a recession. Full employment is the situation in which an economy operates at an unemployment rate equal to the sum of the frictional and structural unemployment rates. This is also called the natural rate of unemployment. The GDP gap is the difference between actual real GDP and potential for full employment real GDP.
The gap between actual and potential real GDP measures the monetary losses of real goods and services to the nation from operating at less than full employment.
Inflation
Inflation is an increase in the general price level of goods and services in the economy. Deflation is the decrease in the general price level of goods and services in the economy. Inflation is an increase in the overall average level of prices and not an increase in the price of any specific product. The consumer price index measures changes in the average prices of consumer goods and services.
The base year is a year chosen as a reference point for comparison with some earlier or later year.
Disinflation is a reduction in the rate of inflation. Nominal income is the actual number of dollars received over a period of time. Real income is the actual number of dollars received adjusted for changes in CPI. People whose nominal income rise faster than the rate of inflation gain purchasing power while people whose nominal incomes do not keep pace with inflation lose purchasing power.
Wealth is the value of stock or assets owned at some point in time. Nominal interest rate is the actual interest rate without adjustment for the inflation rate. The real interest rate is the nominal interest rate minus the inflation rate. An adjustable rate mortgage is a home loan that adjusts the nominal interest rate to changes in an index rate, such as rates on treasury securities. When the real rate of interest is negative, lenders and savers lose because interest earned does not keep up with the inflation rate.
Hyperinflation is an extremely rapid rise in the general price level. Wage price spiral is a situation that occurs when increases in nominal wage rates are passed on in higher prices which result in even higher nominal wage rates and prices. Demand-pull inflation is a rise in the general price level resulting from an excess of total spending. Cost-push inflation is an increase in the general price level resulting from an increase in the cost of production.
Fiscal Policy
Fiscal policy is the use of government spending and taxes to influence the nation’s output, employment, and price level. Discretionary fiscal policy is the deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy.
The spending multiplier is the change in aggregate demand resulting from initial change in any component of aggregate expenditures, including consumption, investment, government spending, and net exports. In the intermediate segment of the aggregate supply curve, the equilibrium real GDP changes by less than the change in government spending times the spending multiplier. Marginal propensity to consume is the change in consumption spending divided by a given change in income.
Any initial change in spending by the government, households, firms, or foreigners on our exports creates a chain reaction of further spending which causes a greater cumulative change in aggregate demand. The marginal propensity to save is the change in saving divided by a change in income. A tax cut has a smaller multiplier effect on aggregate demand than an equal increase in government spending. The tax multiplier is the change in aggregate demand resulting from an initial change in taxes.
Automatic stabilizers are federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction, sometimes referred to as nondiscretionary fiscal policy. Budget surplus is a budget in which government revenues exceed government expenditures in a given time period. A budget deficit is a budget in which government expenditures exceed government revenues in a given time period.
Automatic stabilizers assist in offsetting a recession when real GDP falls and in offsetting inflation when real GDP expands. Supply-side fiscal policy emphasizes government policies that increase aggregate supply in order to achieve long-run growth in real output, full employment, and a lower price level. A laffer curve is a graph depicting the relationship between tax rates and total tax revenues.
Money and the Federal Reserve System
Bartering is the direct exchange of one good or service for another good or service, rather than for money. The use of money simplifies and therefore increases market transactions. Money also prevents wasting time that can be devoted to production, thereby promoting economic growth by increasing a nation’s production possibilities. Money is anything that serves as a medium of exchange, unit of account, and store of value. Medium of exchange is the primary function of money to be widely accepted in exchange for goods and services.
A unit of account is when the function of money provides a common measurement on the relative value of goods and services. A store of value is the ability of money to hold value over time. Money is a useful mechanism for transforming income in the present into future purchases. Money is the most liquid form of wealth because it can be spent directly in the marketplace.
The supply of money must be great enough to meet ordinary transaction needs, but not be so plentiful that it becomes worthless. Commodity money is anything that serves as money while having market value based on the material from which it is made. Fiat money is money accepted by law and not because of its redeemability or tangible value. An item’s ability to serve as money does not depend on its own market value or the backing of precious metal. M1 is the narrowest definition of the money supply. It includes currency and checkable deposits.
Currency is money including coins and paper money. Checkable deposits are the total money in financial institutions that can be withdrawn by writing a check. M2 is the definition of the money supply that equals M1 plus near monies such as savings deposits and small time deposits of less than $100,000. M1 money is more liquid than M2 money.
The federal reserve system is the 12 federal reserve district banks and other financial institutions within each of the federal reserve districts. The board of governors are the seven members appointed by the president and confirmed by the US senate who serve for one nonrenewable 14 year term. Their responsibility is to supervise and control the money supply and the banking system of the United States.
The Federal Open Market Committee directs the buying and selling of US government securities which are major instruments for controlling the money supply. The FOMC consists of the seven members of the Board of governors, the president of the New York federal reserve bank, and the presidents of four other Federal reserve district banks. The federal deposit insurance corporation is a government agency established in 1933 to insure customer deposits to a limit if a bank fails.
The Consumer Financial Protection Bureau is an independent Bureau within the federal reserve that helps consumers make financial decisions. The Monetary Control Act is a law that gave the federal reserve system greater control over nonmember banks and made all financial institutions more competitive.