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versus Movement along a Supply Curve MyLab Economics Concept Check A supply curve shows the relationship between the quantity of a good or service supplied by a firm and the price that good or service brings in the market. Higher prices are likely to lead to an increase in quantity supplied, ceteris paribus. Remember: The supply curve is derived holding everything constant except price. When the price of a product changes ceteris paribus, a change in the quantity supplied follows—that is, a movement along a supply curve takes place. As you have seen, supply decisions are also influenced by factors other than price. New relationships between price and quantity supplied come about when factors other than price change, and the result is a shift of a supply curve. When factors other than price cause supply curves to shift, we say that there has been a change in supply. Recall that the cost of production depends on the price of inputs and the technologies of production available. Now suppose that a major breakthrough in the production of soybeans has occurred: Genetic engineering has produced a superstrain of disease- and pest-resistant seed. Such a technological change would enable individual farmers to supply more soybeans at any market price. Table 3.4 and Figure 3.7 describe this change. At $3 a bushel, farmers would have produced 30,000 bushels from the old seed (schedule S0 in Table 3.4); with the lower cost of production and higher yield resulting from the new seed, they produce 40,000 bushels (schedule S1 in Table 3.4). At $1.75 per bushel, they would have produced 10,000 bushels from the old seed; but with the lower costs and higher yields, output rises to 23,000 bushels. TABLE 3.4 Shift of Supply Schedule for Soybeans following Development of a New Disease-Resistant Seed Strain Price (per Bushel) $ 1.50 1.75 2.25 3.00 4.00 5.00 Schedule S0 Quantity Supplied (Bushels per Year Using Old Seed) Schedule S1 Quantity Supplied (Bushels per Year Using New Seed) 0 10,000 20,000 30,000 45,000 45,000 5,000 23,000 33,000 40,000 54,000 54,000 movement along a supply curve The change in quantity supplied brought about by a change in price. shift of a supply curve The change that takes place in a supply curve corresponding to a
new relationship between quantity supplied of a good and the price of that good. The shift is brought about by a change in the original conditions. M03_CASE3826_13_GE_C03.indd 85 17/04/19 12:10 AM 86 PART I Introduction to Economics ▸ FIGURE 3.7 Shift of the Supply Curve for Soybeans Following Development of a New Seed Strain When the price of a product changes, we move along the supply curve for that product; the quantity supplied rises or falls. When any other factor affecting supply changes, the supply curve shifts. P 3.00 1.75 ) $ ( S1 MyLab Economics Concept Check Bushels of soybeans produced per year 0 10,000 23,000 30,000 40,000 q Increases in input prices may also cause supply curves to shift. If Farmer Brown faces higher fuel costs, for example, his supply curve will shift to the left—that is, he will produce less at any given market price. As Brown’s soybean supply curve shifts to the left, it intersects the price axis at a higher point, meaning that it would take a higher market price to induce Brown to produce any soybeans at all. As with demand, it is important to distinguish between movements along supply curves (changes in quantity supplied) and shifts in supply curves (changes in supply): Change in price of a good or service leads to change in quantity supplied (movement along a supply curve). Change in costs, input prices, technology, or prices of related goods and services leads to change in supply (shift of a supply curve). From Individual Supply to Market Supply MyLab Economics Concept Check So far we have focused on the supply behavior of a single producer. For most markets many, many suppliers bring product to the consumer, and it is the behavior of all of those producers together that determines supply. Market supply is determined in the same fashion as market demand. It is simply the sum of all that is supplied each period by all producers of a single product. Figure 3.8 derives a market supply curve from the supply curves of three individual firms. (In a market with more firms, total market supply would be the sum of the amounts produced by each of the firms in that market.) As the table in Figure 3.8 shows, at a price of $3, farm A supplies 30,000 bushels of soybeans, farm B supplies 10,000 bushels, and farm C supplies 25,000 bus
hels. At this price, the total amount supplied in the market is 30,000 + 10,000 + 25,000, or 65,000 bushels. At a price of $1.75, however, the total amount supplied is only 25,000 bushels (10,000 + 5,000 + 10,000). Thus, the market supply curve is the simple addition of the individual supply curves of all the firms in a particular market—that is, the sum of all the individual quantities supplied at each price. The position and shape of the market supply curve depends on the positions and shapes of the individual firms’ supply curves from which it is derived. The market supply curve also depends on the number of firms that produce in that market. If firms that produce for a particular market are earning high profits, other firms may be tempted to go into that line of business. Think for a moment about the spread of brands of Greek yogurt in the last decade. When new firms enter an industry, the supply curve shifts to the right. When firms go out of business, or “exit” the market, the supply curve shifts to the left. market supply The sum of all that is supplied each period by all producers of a single product. M03_CASE3826_13_GE_C03.indd 86 17/04/19 12:10 AM 3.5 LEARNING OBJECTIVE Be able to explain how a market that is not in equilib- rium responds to restore an equilibrium. Firm A’s supply Firm B’s supply Firm C’s supply CHAPTER 3 Demand, Supply, and Market Equilibrium 87 P 3.00 1.75 SB SA P 3.00 1.75 ) $ (.00 1.75 ) $ ( SC 0 10,000 30,000 q 0 5,000 10,000 q 0 10,000 25,000 q Bushels of soybeans supplied per year Bushels of soybeans supplied per year Bushels of soybeans supplied per year P 3.00 1.75 Market supply curve S SA+B+C Quantity (q) Supplied by C B A Total Quantity Supplied in the Market (Q) 30,000 + 10,000 + 25,000 10,000 + 5,000 + 10,000 5 5 65,000 25,000 Price $3.00 1.75 ) $ ( 25,000 65,000 Q Bushels
of soybeans supplied per year MyLab Economics Concept Check ▴ FIGURE 3.8 Deriving Market Supply from Individual Firm Supply Curves Total supply in the marketplace is the sum of all the amounts supplied by all the firms selling in the market. It is the sum of all the individual quantities supplied at each price. Market Equilibrium So far, we have identified a number of factors that influence the amount that households demand and the amount that firms supply in product (output) markets. The discussion has emphasized the role of market price as a determinant of both quantity demanded and quantity supplied. We are now ready to see how supply and demand in the market interact to determine the final market price. In our discussions, we have separated household decisions about how much to demand from firm decisions about how much to supply. The operation of the market, however, clearly depends on the interaction between suppliers and demanders. At any moment, one of three conditions prevails in every market: (1) The quantity demanded exceeds the quantity supplied at the current price, a situation called excess demand; (2) the quantity supplied exceeds the quantity demanded at the current price, a situation called excess supply; or (3) the quantity supplied equals the quantity demanded at the current price, a situation called equilibrium. At equilibrium, no tendency for price to change exists. Excess Demand MyLab Economics Concept Check Excess demand, or a shortage, exists when quantity demanded is greater than quantity supplied at the current price. Figure 3.9, which plots both a supply curve and a demand curve on the same graph, illustrates such a situation. As you can see, market demand at $1.75 per bushel (50,000 bushels) exceeds the amount that farmers are currently supplying (25,000 bushels). 3.5 LEARNING OBJECTIVE Be able to explain how a market that is not in equilibrium responds to restore an equilibrium. equilibrium The condition that exists when quantity supplied and quantity demanded are equal. At equilibrium, there is no tendency for price to change. excess demand or shortage The condition that exists when quantity demanded exceeds quantity supplied at the current price. M03_CASE3826_13_GE_C03.indd 87 17/04/19 12:10 AM Increases in input prices may also cause supply curves to shift. If Farmer Brown faces higher fuel costs, for example, his supply curve will shift to the left—that is, he will produce less at any given market price. As Brown�
�s soybean supply curve shifts to the left, it intersects the price axis at a higher point, meaning that it would take a higher market price to induce Brown to produce any soybeans at all. As with demand, it is important to distinguish between movements along supply curves (changes in quantity supplied) and shifts in supply curves (changes in supply): Change in price of a good or service leads to change in quantity supplied (movement along a supply curve). Change in costs, input prices, technology, or prices of related goods and services leads to change in supply (shift of a supply curve). From Individual Supply to Market Supply MyLab Economics Concept Check So far we have focused on the supply behavior of a single producer. For most markets many, many suppliers bring product to the consumer, and it is the behavior of all of those producers together that determines supply. Market supply is determined in the same fashion as market demand. It is simply the sum of all that is supplied each period by all producers of a single product. Figure 3.8 derives a market supply curve from the supply curves of three individual firms. (In a market with more firms, total market supply would be the sum of the amounts produced by each of the firms in that market.) As the table in Figure 3.8 shows, at a price of $3, farm A supplies 30,000 bushels of soybeans, farm B supplies 10,000 bushels, and farm C supplies 25,000 bushels. At this price, the total amount supplied in the market is 30,000 + 10,000 + 25,000, or 65,000 bushels. At a price of $1.75, how- ever, the total amount supplied is only 25,000 bushels (10,000 + 5,000 + 10,000). Thus, the market supply curve is the simple addition of the individual supply curves of all the firms in a particular market—that is, the sum of all the individual quantities supplied at each price. The position and shape of the market supply curve depends on the positions and shapes of the individual firms’ supply curves from which it is derived. The market supply curve also de- pends on the number of firms that produce in that market. If firms that produce for a particular market are earning high profits, other firms may be tempted to go into that line of business. Think for a moment about the spread of brands of Greek yogurt in the last decade. When new firms enter an industry
, the supply curve shifts to the right. When firms go out of business, or “exit” the market, the supply curve shifts to the left. market supply The sum of all that is supplied each period by all producers of a single product. 88 PART I Introduction to Economics P 2.00 1.75 ) $ ( Equilibrium point Excess demand 5 shortage D 0 25,000 40,000 50,000 Q Bushels of soybeans MyLab Economics Concept Check ▴ FIGURE 3.9 Excess Demand, or Shortage At a price of $1.75 per bushel, quantity demanded exceeds quantity supplied. When excess demand exists, there is a tendency for price to rise. When quantity demanded equals quantity supplied, excess demand is eliminated and the market is in equilibrium. Here the equilibrium price is $2.00 and the equilibrium quantity is 40,000 bushels. When excess demand occurs in an unregulated market, there is a tendency for price to rise as demanders compete against each other for the limited supply. The adjustment mechanisms may differ, but the outcome is always the same. For example, consider the mechanism of an auction. In an auction, items are sold directly to the highest bidder. When the auctioneer starts the bidding at a low price, many people bid for the item. At first, there is a shortage: Quantity demanded exceeds quantity supplied. As would-be buyers offer higher and higher prices, bidders drop out until the one who offers the most ends up with the item being auctioned. Price rises until quantity demanded and quantity supplied are equal. At a price of $1.75 (see Figure 3.9 again), farmers produce soybeans at a rate of 25,000 bushels per year, but at that price, the demand is for 50,000 bushels. Most farm products are sold to local dealers who in turn sell large quantities in major market centers, where bidding would push prices up if quantity demanded exceeded quantity supplied. As price rises above $1.75, two things happen: (1) The quantity demanded falls as buyers drop out of the market and perhaps choose a substitute, and (2) the quantity supplied increases as farmers find themselves receiving a higher price for their product and shift additional acres into soybean production.3 This process continues until the shortage is eliminated. In Figure 3.9, this occurs at $2.00, where quantity demanded has fallen from 50,000 to 40,000 bushels per year and
quantity supplied has increased from 25,000 to 40,000 bushels per year. When quantity demanded and quantity supplied are equal and there is no further bidding, the process has achieved an equilibrium, a situation in which there is no natural tendency for further adjustment. Graphically, the point of equilibrium is the point at which the supply curve and the demand curve intersect. Increasingly, items are auctioned over the Internet. Companies such as eBay connect buyers and sellers of everything from automobiles to wine and from computers to airline tickets. Auctions are occurring simultaneously with participants located across the globe. The principles through which prices are determined in these auctions are the same: When excess demand 3Once farmers have produced in any given season, they cannot change their minds and produce more, of course. When we derived Clarence Brown’s supply schedule in Table 3.3, we imagined him reacting to prices that existed at the time he decided how much land to plant in soybeans. In Figure 3.9, the upward slope shows that higher prices justify shifting land from other crops. Final price may not be determined until final production figures are in. For our purposes here, however, we have ignored this timing problem. The best way to think about it is that demand and supply are flows, or rates, of production—that is, we are talking about the number of bushels produced per production period. Adjustments in the rate of production may take place over a number of production periods. M03_CASE3826_13_GE_C03.indd 88 17/04/19 12:10 AM CHAPTER 3 Demand, Supply, and Market Equilibrium 89 exists, prices rise. Companies like Uber hire economists to help them calculate “surge” prices to use in times of high demand. When quantity demanded exceeds quantity supplied, price tends to rise. When the price in a market rises, quantity demanded falls and quantity supplied rises until an equilibrium is reached at which quantity demanded and quantity supplied are equal. This process is called price rationing. When the market operates without interference, price increases will distribute what is available to those who are willing and able to pay the most. As long as there is a way for buyers and sellers to interact, those who are willing to pay more will make that fact known somehow. (We discuss the nature of the price system as a rationing device in detail in Chapter 4.) Excess Supply MyLab Economics Concept Check Excess supply, or a surplus, exists when the quantity supplied
exceeds the quantity demanded at the current price. As with a shortage, the mechanics of price adjustment in the face of a surplus can differ from market to market. For example, if automobile dealers find themselves with unsold cars in the fall when the new models are coming in, you can expect to see price cuts. Sometimes dealers offer discounts to encourage buyers; sometimes buyers themselves simply offer less than the price initially asked. After Christmas, most stores have big sales during which they lower the prices of overstocked items. Quantities supplied exceeded quantities demanded at the current prices, so stores cut prices. Many Web sites exist that do little more than sell at a discount clothing and other goods that failed to sell at full price during the past season. Figure 3.10 illustrates another excess supply/surplus situation. At a price of $3 per bushel, suppose farmers are supplying soybeans at a rate of 65,000 bushels per year, but buyers are demanding only 25,000. With 40,000 bushels of soybeans going unsold, the market price falls. As price falls from $3.00 to $2.00, quantity supplied decreases from 65,000 bushels per year to 40,000. The lower price causes quantity demanded to rise from 25,000 to 40,000. At $2.00, quantity demanded and quantity supplied are equal. For the data shown here, $2.00 and 40,000 bushels are the equilibrium price and quantity, respectively. Although the mechanism by which price is adjusted differs across markets, the outcome is the same: When quantity supplied exceeds quantity demanded at the current price, the price tends to fall. When price falls, quantity supplied is likely to decrease and quantity demanded is likely to increase until an equilibrium price is reached where quantity supplied and quantity demanded are equal. excess supply or surplus The condition that exists when quantity supplied exceeds quantity demanded at the current price. ◂ FIGURE 3.10 Excess Supply (Surplus) At a price of $3.00, quantity supplied exceeds quantity demanded by 40,000 bushels. This excess supply will cause the price to fall. P 3.00 2.00 ) $ ( Excess supply 5 surplus S Equilibrium point D 0 25,000 40,000 65,000 Q Bushels of soybeans MyLab Economics Concept Check M03_CASE3826_13_GE_C03.indd 89 17/04/19 12:10 AM 90 PART I Introduction
to Economics Market Equilibrium with Equations MyLab Economics Concept Check So far we have represented demand and supply using schedules and graphs. Economists also use equations when they work with demand and supply. In empirical work, when we begin to measure the quantitative size of markets, equations prove very useful. In order to simplify our work, we can assume that both demand and supply curves are linear (straight) lines. In the demand graph we have been working with, price is generally put on the y axis and quantity on the x axis. This has long been the convention in economics. But in most of our discussions of demand, we think of quantity as the dependent variable and price as the independent variable. That is, we ask: “How many units will the market demand at a given price?,” rather than “What is the price when the demand is Q?” Given that we are working with straight lines, it is a simple matter to move between an equation with price on the right hand side and quantity on the left (formally the demand curve), and one with quantity on the right hand side and price on the left (the inverse demand curve). In their work, economists use both forms. We know already from our graphs that a demand curve intersects the y axis, or the price axis, and that it has a negative slope. If we assume demand is a straight line, then the equation of the inverse demand curve will be of the form P = a - bQd where Qd is the quantity demanded in units and P is the price. “a” is the y intercept, or the price at which quantity demanded is 0, and b is the slope of the demand curve. The demand curve will then be Qd = a b - (1 b)P What about the supply curve? We already know that supply curves have a positive slope, telling us that producers bring more of a good to the market when the price is higher. A supply curve may or may not intersect the y axis (more on this will be in a later chapter), but if it does, and if it is also a straight line, the inverse supply curve will have the form > > P = c + dQs Again, P is price in dollars and Qs is the quantity supplied in units. “c” is the y intercept and d the (positive) slope. Every unit increase in quantity brings with it a d unit increase in price. The supply curve is then Qs = c
d + (1 d)P In our graphs, we found the equilibrium price and quantity by finding the point of intersection of the supply and demand curves. At what price is the quantity demanded equal to the quantity supplied? To find this, we can simply set Qd equal to Qs (and call it Q), which gives us two equations in two unknowns, Q and P, which we can then solve. > > It is easier to proceed at this point using numbers for our intercepts and slopes. Assume that the demand and supply curves can be represented mathematically as: Qd = 14 - 2P Qs = 2 + 4P Setting the quantity demanded equal to the quantity supplied, we have 14 - 2P = 2 + 4P which gives us a price of $2. Substituting back into either the supply or demand equation in turn gives us an equilibrium quantity demanded and supplied of 10 units. Changes in Equilibrium MyLab Economics Concept Check When supply and demand curves shift, the equilibrium price and quantity change. The following example will help to illustrate this point and show us how equilibrium is restored in markets in which either demand or supply changes. M03_CASE3826_13_GE_C03.indd 90 17/04/19 12:10 AM CHAPTER 3 Demand, Supply, and Market Equilibrium 91 South America is a major producer of coffee beans. In the mid-1990s, a major freeze hit Brazil and Colombia and drove up the price of coffee on world markets to a record $2.40 per pound. Bad weather in Colombia in 2005 and more recently in 2012 caused similar shifts in supply. Figure 3.11 illustrates how the freezes pushed up coffee prices. Initially, the market was in equilibrium at a price of $1.20. At that price, the quantity demanded was equal to quantity supplied (13.2 billion pounds). At a price of $1.20 and a quantity of 13.2 billion pounds, the demand curve (labeled D) intersected the initial supply curve (labeled S0). (Remember that equilibrium exists when quantity demanded equals quantity supplied—the point at which the supply and demand curves intersect.) The freeze caused a decrease in the supply of coffee beans. That is, the freeze caused the supply curve to shift to the left. In Figure 3.11, the new supply curve (the supply curve that shows the relationship between price and quantity supplied after the freeze) is labeled S1. At the initial equilibrium price, $
1.20, there is now a shortage of coffee. If the price were to remain at $1.20, quantity demanded would not change; it would remain at 13.2 billion pounds. However, at that price, quantity supplied would drop to 6.6 billion pounds. At a price of $1.20, quantity demanded is greater than quantity supplied. When excess demand exists in a market, price can be expected to rise, and rise it did. As the figure shows, price rose to a new equilibrium at $2.40. At $2.40, quantity demanded is again equal to quantity supplied, this time at 9.9 billion pounds—the point at which the new supply curve (S1) intersects the demand curve. Notice that as the price of coffee rose from $1.20 to $2.40, two things happened. First, the quantity demanded declined (a movement along the demand curve) as people shifted to substitutes such as tea and hot cocoa. Second, the quantity supplied began to rise, but within the limits imposed by the damage from the freeze. (It might also be that some countries or areas with high costs of production, previously unprofitable, came into production and shipped to the world market at the higher price.) P 2.40 1.20 ) $ ( S1 Initial equilibrium S 0 D Excess demand (shortage) at initial price MyLab Economics Concept Check Billions of pounds of coffee per year 0 6.6 9.9 13.2 Q ▴ FIGURE 3.11 The Coffee Market: A Shift of Supply and Subsequent Price Adjustment Before the freeze, the coffee market was in equilibrium at a price of $1.20 per pound. At that price, quantity demanded equaled quantity supplied. The freeze shifted the supply curve to the left (from S0 to S1), increasing the equilibrium price to $2.40. M03_CASE3826_13_GE_C03.indd 91 17/04/19 12:10 AM 92 PART I Introduction to Economics That is, the quantity supplied increased in response to the higher price along the new supply curve, which lies to the left of the old supply curve. The final result was a higher price ($2.40), a smaller quantity finally exchanged in the market (9.9 billion pounds), and coffee bought only by those willing to pay $2.40 per pound. Figure 3.12 summarizes the possible supply and demand shifts that have been discussed and
the resulting changes in equilibrium price and quantity. Study the graphs carefully to ensure that you understand them. e c i r P P1 P0 0 e c i r P P1 P0 0 e c i r P P0 P1 0 1. Increase in income: X is a normal good S D1 D0 Q0 Q1 Quantity 4. Decrease in income: X is an inferior good S D0 D1 Q0 Q1 Quantity 7. Decrease in the price of a substitute for X S D0 D1 Q1 Q0 Quantity 9. Increase in the cost of production of X S1 e c i r P P1 P0 0 e c i r P P0 P1 P1 P0 0 P1 P0 0 S0 D a. Demand shifts 2. Increase in income: X is an inferior good S D0 D1 Q1 Q0 Quantity 3. Decrease in income: X is a normal good S e c i r P P0 P1 0 D0 D1 Q1 Q0 Quantity 5. Increase in the price of a substitute for X 6. Increase in the price of a complement for X S e c i r P P0 P1 0 S D0 D1 Q1 Q0 Quantity D0 D1 Q0 Q1 Quantity 8. Decrease in the price of a complement for X S D1 D0 Q1 Q0 Quantity b. Supply shifts 10. Decrease in the cost of production of X S0 S1 D Q0 Quantity Q1 e c i r P P0 P1 0 Q1 Quantity Q0 MyLab Economics Concept Check ▴ FIGURE 3.12 Examples of Supply and Demand Shifts for Product X M03_CASE3826_13_GE_C03.indd 92 17/04/19 12:10 AM CHAPTER 3 Demand, Supply, and Market Equilibrium 93 Quinoa Those of you who follow a vegetarian diet, or even those of you who are foodies, likely have had quinoa sometime within the last few months. Once eaten mostly by people in Peru and Bolivia, and a reputed favorite of the Incas, quinoa, a highprotein grain, has found a large market among food aficionados. Growth in vegetarianism effectively shifted the demand curve for quinoa to the right. With an upward sloping supply curve, this shift in demand resulted in increased prices. Farmers grew richer, whereas some local consumers found themselves facing higher prices for a
staple product. Over time, these higher prices encouraged more farmers to enter the quinoa market. This shifted the supply curve to the right, helping to moderate the price increases. But quinoa growing turns out to be a tricky affair. Quinoa grows best in high altitudes with cold climates. It thrives on soil fertilized by the dung of herds of llama and sheep. Thus, while supply clearly shifted with new farmer entry, the particular nature of the production process limited that shift and in the end, despite the supply response, prices increased. CRITICAL THINKING 1. Use a graph to show the movement in prices and quantities described in the quinoa market. Demand and Supply in Product Markets: A Review As you continue your study of economics, you will discover that it is a discipline full of controversy and debate. There is, however, little disagreement about the basic way that the forces of supply and demand operate in free markets. If you hear that a freeze in Florida has destroyed a good portion of the citrus crop, you can bet that the price of oranges will rise. If you read that the weather in the Midwest has been good and a record corn crop is expected, you can bet that corn prices will fall. When fishers in Massachusetts go on strike and stop bringing in the daily catch, you can bet that the price of local fish will go up. Here are some important points to remember about the mechanics of supply and demand in product markets: 1. A demand curve shows how much of a product a household would buy if it could buy all it wanted at the given price. A supply curve shows how much of a product a firm would supply if it could sell all it wanted at the given price. 2. Demand and supply can also be represented by equations. 3. Quantity demanded and quantity supplied are always per time period—that is, per day, per month, or per year. 4. The demand for a good is determined by price, household income and wealth, prices of other goods and services, tastes and preferences, and expectations. 5. The supply of a good is determined by price, costs of production, and prices of related products. Costs of production are determined by available technologies of production and input prices. 6. Be careful to distinguish between movements along supply and demand curves and shifts of these curves. When the price of a good changes, the quantity of that good demanded or supplied changes—that is, a movement occurs along the curve. When any other factor that affects supply or demand
changes, the curve shifts, or changes position. 7. Market equilibrium exists only when quantity supplied equals quantity demanded at the current price. The equilibrium price is one for which the supply and demand curves intersect, where the quantity supplied is equal to the quantity demanded. M03_CASE3826_13_GE_C03.indd 93 17/04/19 12:10 AM 94 PART I Introduction to Economics Shrinkflation” during Festive Seasons During festive seasons, such as Christmas, food prices usually rise. The 2017 Christmas was particularly expensive for Britons. The British Retail Consortium reported that Christmas dinner was 16 percent more expensive in 2017 compared to the previous year. While the overall price level in the United Kingdom rose by 3 percent in December 2017, food prices increased by 4.2 percent. Among the sharpest increases was a 40 percent rise in the price of butter, an 8.5 percent rise in the price of fish, an 8.5 percent rise in the prices of beverages, a 5.7 percent rise in vegetable prices, and a 5.6 percent rise in dairy prices. The Office for National Statistics (ONS), the official statistical agency in the United Kingdom, reports that this was the highest level of food prices since 2013. Moreover, the ONS cautioned that food inflation is higher than 4.2 percent due to “shrinkflation,” which means that instead of raising prices during the festive season, producers reduced the weight and size of 2,500 products, out of which 80 percent were food items.1 Changes in tastes, income, wealth, expectations, or prices of other goods and services causes demand to change, while changes in costs, input prices, technology, or prices of related goods and services causes supply to change. Hence, any changes in equilibrium price can be caused either by changes in demand or in supply. As such, an increase in equilibrium price can be caused by either an increase in demand or a fall in supply. The surge in United Kingdom’s food prices is due to the increase in the demand for food items as families stock up food items and other products for the Christmas Eve dinner. This shifts the demand curve to the right, increasing the equilibrium price and quantity demanded as shown in Figure (a). But there could be factors other than the rise in demand that affect prices. On the supply side, the increase in food prices is mainly due to the depreciation of the British pound since the Brexit referendum on June 23, 2016. A weaker pound has increased the
cost of imported food items, shifting the supply curve to the left, further raising the equilibrium price level and reducing the equilibrium quantity as shown in Figure (b). Both forces put together have resulted in a simultaneous rise in prices, but what about the net effect on equilibrium quantity? Recent market research shows that during the festive season of 2017, British consumers spent £1 billion more on food in comparison to the 2016 Christmas. The report explains that the higher food prices left people with less money for other items, so the prices of non-food items have also risen. As higher food prices squeezed the wages of lower income groups, consumer purchases of non-food products fell by 0.1 percent in December 2017 in comparison to the previous month. This was despite discounts on non-food goods such as furniture and clothing.2 Thus, the rightward shift in the demand curve outweighed the leftward shift in the supply curve, causing an overall increase in equilibrium quantity. CRITICAL THINKING 1. Using diagrams, explain what happens to equilibrium price and quantity if the shift in the supply curve outweighs that of the demand curve due to British producers getting bulk export orders. 1 ONS, 2018. Statistical Bulletin: Consumer Price Inflation, UK: January 2018. Office for National Statistics. 2 Fraser McKevitt, 2018. “Bumper Christmas as UK Shoppers Spend £1 Billion More Than Last Year,” Kantar Worldpanel. a. Increase in quantity demanded b. Decrease in quantity demanded P1 P0 D1 D0 P1 P0 S0 S1 D Q0 Q1 Quantity of food Q1 Q0 Quantity of food M03_CASE3826_13_GE_C03.indd 94 17/04/19 12:10 AM CHAPTER 3 Demand, Supply, and Market Equilibrium 95 Looking Ahead: Markets and the Allocation of Resources You can already begin to see how markets answer the basic economic questions of what is produced, how it is produced, and who gets what is produced. A firm will produce what is profitable to produce. If the firm can sell a product at a price that is sufficient to ensure a profit after production costs are paid, it will in all likelihood produce that product. Resources will flow in the direction of profit opportunities. ■■ Demand curves reflect what people are willing and able to pay for products; demand curves are influenced by incomes, wealth, preferences, prices of other goods, and expectations. Because product prices are determined by the interaction of supply
and demand, prices reflect what people are willing to pay. If people’s preferences or incomes change, resources will be allocated differently. Consider, for example, an increase in demand—a shift in the market demand curve. Beginning at an equilibrium, households simply begin buying more. At the equilibrium price, quantity demanded becomes greater than quantity supplied. When there is excess demand, prices will rise, and higher prices mean higher profits for firms in the industry. Higher profits, in turn, provide existing firms with an incentive to expand and new firms with an incentive to enter the industry. Thus, the decisions of independent private firms responding to prices and profit opportunities determine what will be produced. No central direction is necessary. Adam Smith saw this self-regulating feature of markets more than 200 years ago: Every individual... by pursuing his own interest... promotes that of society. He is led... by an invisible hand to promote an end, which was no part of his intention.4 The term Smith coined, the invisible hand, has passed into common parlance and is still used by economists to refer to the self-regulation of markets. ■■ Firms in business to make a profit have a good reason to choose the best available technology—lower costs mean higher profits. Thus, individual firms determine how to produce their products, again with no central direction. ■■ So far, we have barely touched on the question of distribution—who gets what is produced? You can see part of the answer in the simple supply and demand diagrams. When a good is in short supply, price rises. As they do, those who are willing and able to continue buying do so; others stop buying. The next chapter begins with a more detailed discussion of these topics. How, exactly, is the final allocation of resources (the mix of output and the distribution of output) determined in a market system? 4Adam Smith, The Wealth of Nations, Modern Library Edition (New York: Random House, 1937), p. 456 (1st ed., 1776). S U M M A R Y 1. In societies with many people, production must satisfy wide-ranging tastes and preferences, and producers must therefore specialize. 3. Households are the primary consuming units in an economy. All households’ incomes are subject to constraints. 3.1 FIRMS AND HOUSEHOLDS: THE BASIC DECISION-MAKING UNITS p. 70 2. A firm exists when a person or a group of people decides to produce
a product or products by transforming resources, or inputs, into outputs—the products that are sold in the market. Firms are the primary producing units in a market economy. We assume that firms make decisions to try to maximize profits. 3.2 INPUT MARKETS AND OUTPUT MARKETS: THE CIRCULAR FLOW p. 70 4. Households and firms interact in two basic kinds of markets: product or output markets and input or factor markets. Goods and services intended for use by households are exchanged in output markets. In output markets, competing firms supply and competing households demand. In input markets, competing firms demand and competing households supply. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M03_CASE3826_13_GE_C03.indd 95 17/04/19 12:10 AM 96 PART I Introduction to Economics 5. Ultimately, firms choose the quantities and character of outputs produced, the types and quantities of inputs demanded, and the technologies used in production. Households choose the types and quantities of products demanded and the types and quantities of inputs supplied. 3.3 DEMAND IN PRODUCT/OUTPUT MARKETS p. 72 6. The quantity demanded of an individual product by an individual household depends on (1) price, (2) income, (3) wealth, (4) prices of other products, (5) tastes and preferences, and (6) expectations about the future. 7. Quantity demanded is the amount of a product that an indi- vidual household would buy in a given period if it could buy all that it wanted at the current price. 8. A demand schedule shows the quantities of a product that a household would buy at different prices. The same information can be presented graphically in a demand curve. 9. The law of demand states that there is a negative relationship between price and quantity demanded ceteris paribus: As price rises, quantity demanded decreases and vice versa. Demand curves slope downward. 10. All demand curves eventually intersect the price axis because there is always a price above which a household cannot or will not pay. Also, all demand curves eventually intersect the quantity axis because demand for most goods is limited, if only by time, even at a zero price. 11. When an increase in income causes demand for a good to rise, that good is a normal good.
When an increase in income causes demand for a good to fall, that good is an inferior good. 12. If a rise in the price of good X causes demand for good Y to increase, the goods are substitutes. If a rise in the price of X causes demand for Y to fall, the goods are complements. 13. Market demand is simply the sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service. It is the sum of all the individual quantities demanded at each price. 3.4 SUPPLY IN PRODUCT/OUTPUT MARKETS p. 82 14. Quantity supplied by a firm depends on (1) the price of the good or service; (2) the cost of producing the product, which includes the prices of required inputs and the technologies that can be used to produce the product; and (3) the prices of related products. 15. Market supply is the sum of all that is supplied in each period by all producers of a single product. It is the sum of all the individual quantities supplied at each price. 16. It is important to distinguish between movements along demand and supply curves and shifts of demand and supply curves. The demand curve shows the relationship between price and quantity demanded. The supply curve shows the relationship between price and quantity supplied. A change in price is a movement along the curve. Changes in tastes, income, wealth, expectations, or prices of other goods and services cause demand curves to shift; changes in costs, input prices, technology, or prices of related goods and services cause supply curves to shift. 3.5 MARKET EQUILIBRIUM p. 87 17. When quantity demanded exceeds quantity supplied at the current price, excess demand (or a shortage) exists and the price tends to rise. When prices in a market rise, quantity demanded falls and quantity supplied rises until an equilibrium is reached at which quantity supplied and quantity demanded are equal. At equilibrium, there is no further tendency for price to change. 18. When quantity supplied exceeds quantity demanded at the current price, excess supply (or a surplus) exists and the price tends to fall. When price falls, quantity supplied decreases and quantity demanded increases until an equilibrium price is reached where quantity supplied and quantity demanded are equal capital market, p. 71 complements, complementary goods, p. 76 demand curve, p. 74 demand schedule, p. 73 entrepreneur, p. 70 equilibrium, p. 87 excess demand or shortage, p. 87 excess supply
or surplus, p. 89 factors of production, p. 71 firm, p. 70 households, p. 70 income, p. 76 inferior goods, p. 76 input or factor markets, p. 71 labor market, p. 71 land market, p. 71 law of demand, p. 74 law of supply, p. 83 market demand, p. 80 market supply, p. 86 movement along a demand curve, p. 80 movement along a supply curve, p. 85 normal goods, p. 76 perfect substitutes, p. 76 product or output markets, p. 70 profit, p. 83 quantity demanded, p. 72 quantity supplied, p. 83 shift of a demand curve, p. 80 shift of a supply curve, p. 85 substitutes, p. 76 supply curve, p. 83 supply schedule, p. 83 wealth or net worth, p. 76 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M03_CASE3826_13_GE_C03.indd 96 17/04/19 12:10 AM CHAPTER 3 Demand, Supply, and Market Equilibrium 97 P R O B L E M S All problems are available on MyLab Economics. 3.1 FIRMS AND HOUSEHOLDS: THE BASIC DECISION-MAKING UNITS LEARNING OBJECTIVE: Understand the roles of firms, entrepreneurs, and households in the market. 1.1 List three examples of entrepreneurs in the tech industry and the firms they created. Explain how these people fit the definition of entrepreneur. 3.2 INPUT MARKETS AND OUTPUT MARKETS: THE CIRCULAR FLOW LEARNING OBJECTIVE: Understand the role of households as both suppliers to firms and buyers of what firms produce. 2.1 Identify whether each of the following transactions will take place in an input market or in an output market, and whether firms or households are demanding the good or service, or supplying the good or service. a. Jan works 40 hours a week at Rutgers University, New Jersey. b. Maili decides to tour Central Asia during her summer vacation. c. Ford closes one of its factories in the United States due to increasing steel prices. d. The Zhao Company acquires a housing project in Hong Kong so they can build new and more expensive condos. 3.3 DEMAND IN PRODUCT/OUTPUT
MARKETS LEARNING OBJECTIVE: Understand what determines the position and shape of the demand curve and what factors move you along a demand curve and what factors shift the demand curve. 3.1 [Related to the Economics in Practice on p. 77] Some airplane manufacturers offer merchandise such as airplane models at their official online stores. Suppose you wish to purchase an authentic Boeing airplane model. Go to the Boeing Store’s Website at boeingstore.com and click on “Models.” Select an airplane model and find its price. Do the same for two other models. Would the models you selected be considered as perfect substitutes or just substitutes? Why? Do you think there are other products available that would be considered substitute for the authentic models you looked up? Briefly explain. 3.2 Explain whether each of the following statements de- scribes a change in demand or a change in quantity demanded, and specify whether each change represents an increase or a decrease. a. Julia believes the price of tires will rise next month, so she purchases a set of four for her pickup truck today. b. After an article is published asserting that eating quinoa causes hair loss, sales of quinoa drop by 75 percent. c. The Oink-N-Chew company experiences a significant decline in sales when it doubles the price of its bacon-flavored bubblegum. d. An increase in the federal minimum wage results in a decline in sales of fast food. e. An unexpected decrease in the price of peanut butter results in an increase in banana sales. 3.3 For each of the five statements (a–e) in the previous question, draw a demand graph representing the appropriate change in quantity demanded or change in demand. 3.4 [Related to the Economics in Practice on p. 78] In 2015, it was disclosed that the water supplied at several Hong Kong public housing estates contained dangerous amounts of lead. The level of lead in the water samples taken from the area exceeded the World Health Organization’s guideline of 10 micrograms for drinking water. Lead poisoning can cause multi-organ failure and damage the nervous system. This unexpected incident resulted in a significant increase in household purchases of water filters. Which determinants of demand were the most likely factors in the households’ decisions to purchase water filters? How would these purchases affect the demand curve for water filters? 3.4 SUPPLY IN PRODUCT/OUTPUT MARKETS LEARNING OBJECTIVE: Be able to distinguish between
forces that shift a supply curve and changes that cause a movement along a supply curve. 4.1 The market for fitness trackers is made up of five firms, and the data in the following table represents each firm’s quantity supplied at various prices. Fill in the column for the quantity supplied in the market, and draw a supply graph showing the market data. Quantity supplied by: PRICE FIRM A FIRM B FIRM C FIRM D FIRM E MARKET $ 25 50 75 100 5 7 9 11 3 5 7 10 2 5 8 11 0 3 6 9 5 6 7 8 4.2 The following sets of statements contain common errors. Identify and explain each error: a. Supply decreases, causing prices to rise. Higher prices cause supply to increase. Therefore, prices fall back to their original levels. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M03_CASE3826_13_GE_C03.indd 97 17/04/19 12:10 AM 98 PART I Introduction to Economics b. The supply of pineapples in Hawaii increases, caus- c. During 2009, incomes fell sharply due to the financial ing pineapple prices to fall. Lower prices mean that the demand for pineapples in Hawaiian households will increase, which will reduce the supply of pineapples and increase their price. 3.5 MARKET EQUILIBRIUM LEARNING OBJECTIVE: Be able to explain how a market that is not in equilibrium responds to restore an equilibrium. 5.1 Illustrate the following with supply and demand curves: a. With increased access to wireless technology and lighter weight, the demand for 2-in-1 laptop computers has increased substantially. 2-in-1 laptops have also become easier and cheaper to produce as new technology has come online. Despite the shift of demand, prices have fallen. b. Cranberry production in Massachusetts totaled 1.91 million barrels in 2017, a 16 percent decrease from the 2.22 million barrels produced in 2016. Demand also decreased, but by less than than supply, raising 2017 prices to $48.70 per barrel from $44.50 in 2016. c. During the high-tech boom in the late 1990s, San Jose office space was in high demand and rents were high. With the national recession that began in March 2001, however, the market for office
space in San Jose (Silicon Valley) was hit hard, with rents per square foot falling. In 2005, the employment numbers from San Jose were rising slowly and rents began to rise again. Assume for simplicity that no new office space was built during the period. d. Before economic reforms were implemented in the countries of Eastern Europe, regulation held the price of bread substantially below equilibrium. When reforms were implemented, prices were deregulated and the price of bread rose dramatically. As a result, the quantity of bread demanded fell and the quantity of bread supplied rose sharply. e. The steel industry has been lobbying for high tariffs on imported steel. Russia, Brazil, and Japan have been producing and selling steel on world markets at $593 per metric ton, well below what equilibrium would be in the United States with no imports. If no imported steel was permitted into the country, the equilibrium price would be $1,006 per metric ton. Show supply and demand curves for the United States, assuming no imports; then show what the graph would look like if U.S. buyers could purchase all the steel that they wanted from world markets at $593 per metric ton; label the portion of the graph that represents the quantity of imported steel. 5.2 Do you agree or disagree with each of the following state- ments? Briefly explain your answers and illustrate each with supply and demand curves. a. The price of coffee rises, causing the demand for sugar to decrease. Therefore, the two goods are substitutes. b. A decrease in supply causes the price of coffee to fall. crisis of 2008–2009. This change likely led to a decrease in the prices of both normal and inferior goods. d. If both coffee and tea are normal goods and the price of coffee increases, it will increase the demand for tea. e. If the price of lemonade decreases due to insufficient demand, and its supply decreases at the same time, the equilibrium price will clearly rise. f. The price of milk falls. This causes an increase in the price of coffee. Therefore, milk and coffee are substitutes. 5.3 In the last decade, the member states of the European Union (EU) agreed to reduce tobacco consumption in their countries. This agreement was followed by a steady increase in the taxes on tobacco and, at the same time, a ban on smoking in bars or cafés across most countries in the EU. In addition, tobacco advertising was heavily regulated to make the public aware of the health dangers of smoking. Were these actions aligned with each
other given the goal to reduce tobacco consumption? Illustrate with the help of a graph. 5.4 For each of the following statements, draw a diagram that illustrates the likely effect on the market for eggs. Indicate in each case the impact on equilibrium price and equilibrium quantity. a. The surgeon general warns that high-cholesterol foods cause heart attacks. b. The price of bacon, a complementary product, decreases. c. The price of chicken feed increases. d. Caesar salads become trendy at dinner parties. (The dress- ing is made with raw eggs.) e. A technological innovation reduces egg breakage during packing. *5.5 Suppose the demand and supply curves for rice in Japan are given by the following equations: Qd = 120 - 30 P Qs = 40 + 10 P where Qd = millions of tons of rice the Japanese would like to buy each year; Qs = millions of tons of rice Japanese farmers would like to sell each year; and P = price per ton of rice (in hundreds of $). a. Fill in the following table: Price (Per Ton) Quantity Demanded (Qd) Quantity Supplied (Qs) $.50 $ 1.00 $ 1.50 $ 2.00 $ 2.50 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ b. Use the information in the table to find the equilibrium price and quantity. c. Graph the demand and supply curves and identify the equilibrium price and quantity. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M03_CASE3826_13_GE_C03.indd 98 17/04/19 12:10 AM 5.6 Education policy analysts debate the best way to support low-income households to afford quality education. One strategy—the demand-side strategy—is to provide people with education vouchers, paid for by the government, that can be used to pay a part of tuition fee for private schools. Another—the supply-side strategy—is to have the government subsidize private schools or to establish more public schools. a. Illustrate these supply- and demand-side strategies using supply and demand curves. Which results in higher tuition fees? b. Critics of education vouchers (the demand-side strategy) argue that because the supply of education to low-income households is limited
and does not respond to higher tuition fees, demand vouchers will serve only to drive up tuition fees and make private schools better off. Illustrate their point with supply and demand curves. 5.7 Suppose the market demand for pizza is given by Qd = 300 - 20P and the market supply for pizza is given by Qs = 20P - 100, where P = price (per pizza). a. Graph the supply and demand schedules for pizza using $5 through $15 as the value of P. b. In equilibrium, how many pizzas would be sold and at what price? c. What would happen if suppliers set the price of pizza at $15? Explain the market adjustment process. d. Suppose the price of hamburgers, a substitute for pizza, doubles. This leads to a doubling of the demand for pizza. (At each price, consumers demand twice as much pizza as before.) Write the equation for the new market demand for pizza. e. Find the new equilibrium price and quantity of pizza. Note: Problems with an asterisk are more challenging. CHAPTER 3 Demand, Supply, and Market Equilibrium 99 5.8 [Related to the Economics in Practice on p. 93] The growing popularity of quinoa has had an impact on the market for brown rice. With its higher fiber, protein, and iron content, quinoa is replacing brown rice as a staple food for many health-conscious individuals. Draw a supply and demand graph that shows how this increase in demand for quinoa has affected the market for brown rice. Describe what has happened to the equilibrium price and quantity of brown rice. What could brown rice producers do to return the price or quantity to the initial equilibrium price or quantity? Briefly explain if it is possible for brown rice producers to return both the price and quantity to the initial equilibriums without a change in consumer behavior. 5.9 The following table represents the market for solar wireless keyboards. Plot this data on a supply and demand graph and identify the equilibrium price and quantity. Explain what would happen if the market price is set at $60, and show this on the graph. Explain what would happen if the market price is set at $30, and show this on the graph. Price $ 10.00 20.00 30.00 40.00 50.00 60.00 70.00 Quantity Demanded Quantity Supplied 28 24 20 16 12 8 4 0 3 6 9 12 15 18 QUESTION 1 This summer, it was difficult to find peaches
in Florida grocery stores. What does this indicate about the market for peaches and the current price of a peach? QUESTION 2 Over the past decade, the price of beef has risen, and consumers have purchased less beef. Analysts have offered various explanations for these trends. Analyst 1, for example, claims that this is due to consumers’ preference for healthier eating. Analyst 2 claims, instead, that this is due to increasing costs of raising cattle. Is one of these assertions more sensible than the other? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M03_CASE3826_13_GE_C03.indd 99 17/04/19 12:10 AM 4 Demand and Supply Applications 4.1 LEARNING OBJECTIVE Understand how price floors and price ceilings work in the market place. CHAPTER OUTLINE AND LEARNING OBJECTIVES 4.1 The Price System: Rationing and Allocating Resources p. 101 Understand how price floors and price ceilings work in the market place. 4.2 Supply and Demand Analysis: Tariffs (Tax) p. 108 Analyze the economic impact of an oil import tariff (tax). 4.3 Supply and Demand and Market Efficiency p. 110 Explain how consumer and producer surplus are generated. Looking Ahead p. 114 100 Every society has a system of institutions that determines what is produced, how it is produced, and who gets what is produced. In some societies, many of these decisions are made centrally, through planning agencies or by government directive. However, in every society, many decisions are made in a decentralized way, through the operation of markets. Markets exist in all societies, and Chapter 3 provided a bare-bones description of how markets operate. In this chapter, we continue our examination of demand, supply, and the price system. M04_CASE3826_13_GE_C04.indd 100 17/04/19 12:12 AM CHAPTER 4 Demand and Supply Applications 101 The Price System: Rationing and Allocating Resources The market system, also called the price system, performs two important and closely related functions. First, it provides an automatic mechanism for distributing scarce goods and services. That is, it serves as a price rationing device for allocating goods and services to consumers when the quantity demanded exceeds the quantity supplied. Second, the price system ultimately determines
both the allocation of resources among producers and the final mix of outputs. 4.1 LEARNING OBJECTIVE Understand how price floors and price ceilings work in the market place. price rationing The process by which the market system allocates goods and services to consumers when quantity demanded exceeds quantity supplied. Price Rationing MyLab Economics Concept Check Consider the simple process by which the price system eliminates a shortage. Figure 4.1 shows hypothetical supply and demand curves for wheat. Wheat is produced around the world, with large supplies coming from Russia and from the United States. Wheat is sold in a world market and is used to produce a range of food products, from cereals and breads to processed foods, which line the kitchens of the average consumer. Wheat is thus demanded by large food companies as they produce breads, cereals, and cake for households. Figure 4.1 shows the equilibrium price of wheat is $160 per metric ton. At this price, farmers from around the world are expected to bring 60 million metric tons to market, which was equal to what consumers wanted at that price. Supply and demand were equal. (Remember that equilibrium occurs at the point where the supply and demand curves intersect. In Figure 4.1, this occurs at point C.) Now suppose that one of the larger producing countries, perhaps Russia, experiences an exceptionally warm summer and this heat and the fires it brought destroy a substantial portion of their wheat crop. With almost a third of the world wheat normally produced in Russia, the effect of this environmental disaster on the world wheat supply would be substantial. In the figure, the supply curve for wheat, which had been drawn in expectation of harvesting all the wheat planted in Russia along with the rest of the world, now shifts to the left, from Sspring 2010 to Sfall 2010. This shift in the supply curve creates a situation of excess demand at the old price of $160. At that price, the quantity demanded is 60 million metric tons, but the burning of much of the Russia supply left the world with only 35 million metric tons expected to be supplied. Quantity demanded exceeds quantity supplied at the original price by 25 million metric tons. The reduced supply causes the price of wheat to rise sharply. As the price rises, the available supply is “rationed.” Those who are willing and able to pay the most get the wheat. You can see the market’s rationing function clearly in Figure 4.1. As the price rises from $160, the quantity P 247 160 )
$ ( Sfall 2010 Sspring 2010 B A C D ◂◂ FIGURE 4.1 The Market for Wheat Fires in Russia in the summer of 2010 caused a shift in the world’s supply of wheat to the left, causing the price to increase from $160 per metric ton to $247. The equilibrium moved from C to B. 0 35 40 60 Q Millions of metric tons of wheat MyLab Economics Concept Check M04_CASE3826_13_GE_C04.indd 101 17/04/19 12:12 AM Every society has a system of institutions that determines what is produced, how it is produced, and who gets what is produced. In some societies, many of these decisions are made centrally, through planning agencies or by government directive. However, in every society, many deci- sions are made in a decentralized way, through the operation of markets. Markets exist in all societies, and Chapter 3 provided a bare-bones description of how mar- kets operate. In this chapter, we continue our examination of demand, supply, and the price system. 102 PART I Introduction to Economics demanded declines along the demand curve, moving from point C (60 million metric tons) toward point B (40 million metric tons). The higher prices mean that prices for products like Pepperidge Farm bread and Shredded Wheat cereal, which use wheat as an essential ingredient, also rise. People begin to eat more rye bread and switch from Shredded Wheat to Corn Flakes in response to the price changes. As prices rise, wheat farmers also change their behavior, though supply responsiveness is limited in the short term. Farmers outside of Russia, seeing the price rise, harvest their crops more carefully, getting more precious grains from each stalk. Perhaps some wheat is taken out of storage and brought to market. Quantity supplied increases from 35 million metric tons (point A) to 40 million metric tons (point B). The price increase has encouraged farmers who can to make up for part of the Russia wheat loss. A new equilibrium is established at a price of $247 per metric ton, with 40 million tons transacted. The market has determined who gets the wheat: The lower total supply is rationed to those who are willing and able to pay the higher price. This idea of “willingness to pay” is central to the distribution of available supply, and willingness depends on both desire (preferences) and income/wealth. Willingness to pay does not necessarily mean that only
the rich will continue to buy wheat when the price increases. For anyone to continue to buy wheat at a higher price, his or her enjoyment comes at a higher cost in terms of other goods and services. Even high-income people may decide that their preference for wheat bread over rye is not strong enough to offset the new higher price of wheat. In sum: The adjustment of price is the rationing mechanism in free markets. Price rationing means that whenever there is a need to ration a good—that is, when a shortage exists—in a free market, the price of the good will rise until quantity supplied equals quantity demanded— that is, until the market clears. There is some price that will clear any market you can think of. Consider the market for a famous painting such as Jackson Pollock’s No. 5, 1948, illustrated in Figure 4.2. There is only one such painting no matter what price is offered. At a low price, there would be an enormous excess demand for such an important painting. The price would be bid up until there was only one remaining demander. Presumably, that price would be very high. In fact, the Pollock painting sold for a record $140 million in 2006. If the product is in strictly scarce supply, as a single painting is, S 140,000,000 ) $ ( e c i r P D MyLab Economics Concept Check Quantity of Jackson Pollock’s “No. 5, 1948” 0 1 ◂▴ FIGURE 4.2 Market for a Rare Painting There is some price that will clear any market, even if supply is strictly limited. In an auction for a unique painting, the price (bid) will rise to eliminate excess demand until there is only one bidder willing to purchase the single available painting. Some estimate that the Mona Lisa would sell for $600 million if auctioned. M04_CASE3826_13_GE_C04.indd 102 17/04/19 12:12 AM CHAPTER 4 Demand and Supply Applications 103 its price is said to be demand-determined. That is, its price is determined solely and exclusively by the amount that the highest bidder or highest bidders are willing to pay. One might interpret the statement that “there is some price that will clear any market” to mean “everything has its price,” but that is not exactly what it means. Suppose you own a small silver bracelet that has been in your family for generations
. It is quite possible that you would not sell it for any amount of money. Does this mean that the market is not working, or that quantity supplied and quantity demanded are not equal? Not at all, it simply means that you are the highest bidder. By turning down all bids, you must be willing to forgo what anybody offers for it. Constraints on the Market and Alternative Rationing Mechanisms MyLab Economics Concept Check On occasion, both governments and private firms decide to use some mechanism other than the market system to ration an item for which there is excess demand at the current price. Policies designed to stop price rationing are commonly justified in a number of ways. The rationale most often used is fairness. It is not “fair” to let landlords charge high rents, not fair for oil companies to run up the price of gasoline, not fair for insurance companies to charge enormous premiums, and so on. After all, the argument goes, we have no choice but to pay—housing and insurance are necessary, and one needs gasoline to get to work. The Economics in Practice box on page 105 describes complaints against price increases following floods in countries like Malaysia, India, Africa, and Australia. Regardless of the rationale for controlling prices, the following examples will make it clear that trying to bypass the pricing system is often more difficult and more costly than it first appears. Oil, Gasoline, and OPEC One of the most important prices in the world is the price of crude oil. Millions of barrels of oil are traded every day. It is a major input into virtually every product produced. It heats our homes, and it is used to produce the gasoline that runs our cars. Its production has led to massive environmental disasters as well as wars. Its price has fluctuated wildly, leading to major macroeconomic problems. But oil is like other commodities in that its price is determined by the basic forces of supply and demand. Oil provides a good example of how markets work and how markets sometimes fail. The Organization of the Petroleum Exporting Countries (OPEC) is an organization of fourteen countries (Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela) that together produced about 40 percent of the world’s crude oil in 2018. In 1973 and 1974, OPEC imposed an embargo on shipments of crude oil to the United States. What followed was a drastic reduction in the quantity of gasoline available at local
gas pumps, given the large market share of OPEC at the time. Had the market system been allowed to operate, refined gasoline prices would have increased dramatically until quantity supplied was equal to quantity demanded. However, the U.S. government decided that rationing gasoline only to those who were willing and able to pay the most was unfair, and Congress imposed a price ceiling, or maximum price, of $0.57 per gallon of leaded regular gasoline. That price ceiling was intended to keep gasoline “affordable,” but it also perpetuated the shortage. At the restricted price, quantity demanded remained greater than quantity supplied, and the available gasoline had to be divided up somehow among all potential demanders. You can see the effects of the price ceiling by looking carefully at Figure 4.3. If the price had been set by the interaction of supply and demand, it would have increased to approximately $1.50 per gallon. Instead, Congress made it illegal to sell gasoline for more than $0.57 per gallon. At that price, quantity demanded exceeded quantity supplied and a shortage existed. Because the price system was not allowed to function, an alternative rationing system had to be found to distribute the available supply of gasoline. Several devices were tried. The most common of all nonprice rationing systems is queuing, a term that means waiting in line. During 1974, long lines formed daily at gas stations, starting price ceiling A maximum price that sellers may charge for a good, usually set by government. queuing Waiting in line as a means of distributing goods and services: a nonprice rationing mechanism. M04_CASE3826_13_GE_C04.indd 103 17/04/19 12:12 AM 104 PART I Introduction to Economics P 1.50 0.57 ) $ ( S1974 D1974 favored customers Those who receive special treatment from dealers during situations of excess demand. ration coupons Tickets or coupons that entitle individuals to purchase a certain amount of a given product per month. 0 Quantity supplied Quantity demanded Q Excess demand or shortage Gallons per year MyLab Economics Concept Check ◂▴ FIGURE 4.3 Excess Demand (Shortage) Created by a Price Ceiling In 1974, a ceiling price of $0.57 cents per gallon of leaded regular gasoline was imposed. If the price had been set by the interaction of supply and demand instead, it would have increased to approximately $1.50 per gallon. At $0.57 per gallon, the quantity
demanded exceeded the quantity supplied. Because the price system was not allowed to function, an alternative rationing system had to be found to distribute the available supply of gasoline. as early as 5 am. Under this system, gasoline went to those people who were willing to pay the most, but the sacrifice was measured in hours and aggravation instead of dollars.1 A second nonprice rationing device used during the gasoline crisis was that of favored customers. Many gas station owners decided not to sell gasoline to the general public, but to reserve their scarce supplies for friends and favored customers. Not surprisingly, many customers tried to become “favored” by offering side payments to gas station owners. Owners also charged high prices for service. By doing so, they increased the actual price of gasoline, but hid it in service overcharges to get around the ceiling. Yet another method of dividing up available supply is the use of ration coupons. It was suggested in both 1974 and 1979 that families be given ration tickets or coupons that would entitle them to purchase a certain number of gallons of gasoline each month. That way, everyone would get the same amount regardless of income. Such a system was employed in the United States during the 1940s when wartime price ceilings on meat, sugar, butter, tires, nylon stockings, and many other items were imposed. When ration coupons are used with no prohibition against trading them, however, the result is almost identical to a system of price rationing. Those who are willing and able to pay the most buy up the coupons and use them to purchase gasoline, chocolate, fresh eggs, or anything else 1 You can also show formally that the result is inefficient—that there is a resulting net loss of total value to society. First, there is the cost of waiting in line. Time has a value. With price rationing, no one has to wait in line and the value of that time is saved. Second, there may be additional lost value if the gasoline ends up in the hands of someone who places a lower value on it than someone else who gets no gas. Suppose, for example, that the market price of gasoline if unconstrained would rise to $2 but that the government has it fixed at $1. There will be long lines to get gas. Imagine that to motorist A, 10 gallons of gas is worth $35, but that she fails to get gas because her time is too valuable to wait in line. To motorist B, 10 gallons is worth only $15, but his time is worth
much less, so he gets the gas. In the end, A could pay B for the gas and both would be better off. If A pays B $30 for the gas, A is $5 better off and B is $15 better off. In addition, A does not have to wait in line. Thus, the allocation that results from nonprice rationing involves a net loss of value. Such losses are called deadweight losses. See p. 113 of this chapter. M04_CASE3826_13_GE_C04.indd 104 17/04/19 12:12 AM Why Do I Have to Pay More for My Food? The Truth behind the Flood Crises CHAPTER 4 Demand and Supply Applications 105 Every year West African and Asian-Australian monsoons hit countries like Malaysia, India, Africa, and Australia, resulting in severe floods with a devastating economic impact. In the aftermath of such crises, prices of goods and services in affected industries begin to rise. At this point, you should be able to anticipate which prices are likely to rise the most. Before the floods, the markets in the countries are assumed to be in relative equilibrium. However, this pre-monsoon market equilibrium is not sustainable after the floods. Businesses that are inclined to increase the prices of their products will see either a large shift to the right or to the left of their demand and supply curves. Extreme weather conditions tend to result in a significant decline in the production of food items and other necessity goods. Farmers and fishermen are forced to avoid choppy seas and, often, have to abandon their homes. Thus, due to fewer catches, the price of seafood soars along coastal regions like the eastern coast of Malaysia. At the same time, vegetable prices and the cost of vegetable oil used by food industries see an even greater price jump due to farmlands and oil plantations being submerged after the floods. This causes food supplies to become scarce while damaged infrastructure limits access to markets. Certain services—pest control, sewage cleaning, water pumping machine rental, potholes repair, and improvised boats—become highly valued. A shift in the supply curve makes higher prices possible in such markets, particularly given the fact that most people who remain in the affected regions really need those products and services! As suggested in the text, in some cases governments implement price controls during crises. In the aftermath of severe floods, sharp increases in the prices of necessity goods and services is a common phenomenon known as price gouging. To combat it,
governments incorporate anti-price gouging provisions into consumer protection acts or emergency management legislation and regulations. In Australia, price gouging is regulated at both the Federal and the State levels through Section 21 on unconscionable conduct in its consumer law.1 However, the law on price gouging is less precise in some African states with armed conflicts and humanitarian aids. Though the extent of price gouging is not easily defined, economic theory can help predict the types of businesses that are liable for such offense. CRITICAL THINKING 1. In what ways can governments reduce the severity of the leftward shift of the supply curve during emergency situations? When would price gouging be considered good within the economics perspective? Should it be legalized? Why or why not? 1Warren Barnsley, “Insurance Companies Accused of ‘Gouging’ Queenslanders,” Brisbane Times, March 17, 2014; Government of Malaysia, 2011, Price Control and Anti-Profiteering Act 2011, Act 723, Article 14: Offence to Profiteer and Article 18: Penalty; and “Somalia profile – Overview,” BBC, Africa, January 2018. that is sold at a restricted price.2 This means that the price of the restricted good will effectively rise to the market-clearing price. For instance, suppose that you decide not to sell your ration coupon. You are then forgoing what you would have received by selling the coupon. Thus, the “effective” price of the good you purchase will be higher (if only in opportunity cost) than the restricted price. Even when trading coupons is declared illegal, it is virtually impossible to stop black markets from developing. In a black market, illegal trading takes place at market- determined prices. Rationing Mechanisms for Concert and Sports Tickets Tickets for sporting events, hit shows on Broadway, and concerts sometimes command huge prices in the open market. In many cases, the prices are substantially above the original issue price. One of the hottest theater tickets in 2017 was to Lin Manuel Miranda’s rap musical Hamilton, on Broadway in New York City, with single tickets selling for more than $1,000. 2 Of course, if you are assigned a number of tickets and you sell them, you are better off than you would be with price rationing. Ration coupons thus serve as a way of redistributing income. black market A market in which illegal trading takes place at market-determined prices. M04_C
ASE3826_13_GE_C04.indd 105 17/04/19 12:12 AM 106 PART I Introduction to Economics In many cases, the high price for tickets is charged not by the original sellers—theater producers or sports teams—but by scalpers, people who buy the tickets in the hope of reselling them for a profit. Stub Hub is one of several companies that have grown up to make profits in this resale market. You might ask why a profit-maximizing enterprise would not charge the highest price it could, but leave it to scalpers to make all the money? The answer depends on the event. In the case of sporting events, the high price tickets often come from the end of season championship games. When the Chicago Cubs finally got into the World Series in 2016, the price of a ticket on the resale market was about $3,500. But if the Cubs actually charged $3,500 a ticket, which the market shows us is the true value of the ticket, the hard-working fans would be furious: the headlines would scream “Greedy Cubs Gouge Fans”. Ordinary loyal fans earning reasonable salaries would not be able to afford those prices. Next season, perhaps some of those irate fans would change loyalties, supporting the White Sox over the Cubs. In part to keep from alienating loyal fans, prices for championship games are often held down. Many theater producers also worry about fan reaction when prices of tickets soar. In the case of Hamilton on Broadway, every week a number of free tickets were given out to New York residents. When Harry Potter and the Cursed Child opened in New York in 2018, producers had a series of Friday “lotteries” in which theater-goers could win the right to buy low-priced tickets to that week’s show. In still other cases, producers set ticket prices before they realized how popular an event would be and the lucky early purchasers could either enjoy the production at low prices or resell their tickets to a higher demander and spend the money on something else. It is interesting to look at what happens when a seller, perhaps for reasons of fairness, sets the price below what she or he thinks the market will bear. Let’s consider a concert at the Staples Center, which has 20,000 seats. The supply of tickets is thus fixed at 20,000. Of course, there are good seats and bad seats, but to keep things simple,
let’s assume that all seats are the same and that the promoters charge $50 per ticket for all tickets, hoping to keep their concert affordable for their fans. This example is illustrated in Figure 4.4. Supply is represented by a vertical line at 20,000. Changing the price does not change the supply of seats. In the figure, the quantity demanded at the price of $50 is 38,000, so at this price there is excess demand of 18,000. Who would get to buy the $50 tickets, given that more people want them than we have seats available? As in the case of gasoline, a variety of rationing mechanisms might be used. The most ◂▸ FIGURE 4.4 Supply of and Demand for a Concert at the Staples Center At the face-value price of $50, there is excess demand for seats to the concert. At $50 the quantity demanded is greater than the quantity supplied, which is fixed at 20,000 seats. The diagram shows that the quantity demanded would equal the quantity supplied at a price of $300 per ticket. S P 300 ) $ ( e c i r P Excess demand = shortage 50 D MyLab Economics Concept Check Tickets to a concert at the Staples Center 20,000 Quantity supplied 38,000 Quantity demanded Q M04_CASE3826_13_GE_C04.indd 106 17/04/19 12:12 AM CHAPTER 4 Demand and Supply Applications 107 common is queuing, waiting in line. The tickets would go on sale at a particular time, and people would show up and wait. Now ticket sellers have virtual waiting rooms online. There are also, of course, favored customers. Those who get tickets without queuing are local politicians, sponsors, and friends of the artist or friends of the players. But “once the dust settles,” the power of technology and the concept of opportunity cost take over. Even if you get the ticket for the (relatively) low price of $50, that is not the true cost. The true cost is what you give up to sit in the seat. If people on eBay, StubHub, or Ticketmaster are willing to pay $300 for your ticket, that’s what you must pay, or sacrifice, to go to the concert. Many people—even strong fans—will choose to sell that ticket. Once again, it is difficult to stop the market from rationing the tickets to those people who are willing and able to pay the
most. No matter how good the intentions of private organizations and governments, it is difficult to prevent the price system from operating and to stop people’s willingness to pay from asserting itself. Every time an alternative is tried, the price system seems to sneak in the back door. With favored customers and black markets, the final distribution may be even more unfair than what would result from simple price rationing. Prices and the Allocation of Resources MyLab Economics Concept Check Thinking of the market system as a mechanism for allocating scarce goods and services among competing demanders is revealing, but the market determines more than just the distribution of final outputs. It also determines what gets produced and how resources are allocated among competing uses. Consider a change in consumer preferences that leads to an increase in demand for a specific good or service. During the 1980s, for example, people began going to restaurants more frequently than before. Researchers think that this trend, which continues today, is partially the result of social changes (such as a dramatic rise in the number of two-earner families) and partially the result of rising incomes. The market responded to this change in demand by shifting resources, both capital and labor, into more and better restaurants. With the increase in demand for restaurant meals, the price of eating out rose and the restaurant business became more profitable. The higher profits attracted new businesses and provided old restaurants with an incentive to expand. As new capital, seeking profits, flowed into the restaurant business, so did labor. New restaurants need chefs. Chefs need training, and the higher wages that came with increased demand provided an incentive for them to get it. In response to the increase in demand for training, new cooking schools opened and existing schools began to offer courses in the culinary arts. This story could go on and on, but the point is clear: Price changes resulting from shifts of demand in output markets cause profits to rise or fall. Profits attract capital; losses lead to disinvestment. Higher wages attract labor and encourage workers to acquire skills. At the core of the system, supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of goods and services produced. Price Floor MyLab Economics Concept Check As we have seen, price ceilings, often imposed because price rationing is viewed as unfair, result in alternative rationing mechanisms that are inefficient and may be equally unfair. Some of the same arguments can be made for price floors. A price floor is a minimum price below which exchange is not permitted. If a
price floor is set above the equilibrium price, the result will be excess supply; quantity supplied will be greater than quantity demanded. The most common example of a price floor is the minimum wage, which is a floor set for the price of labor. Employers (who demand labor) are not permitted under federal law to pay a wage less than $7.25 per hour (in 2018) to workers (who supply labor). price floor A minimum price below which exchange is not permitted. minimum wage A price floor set for the price of labor. M04_CASE3826_13_GE_C04.indd 107 17/04/19 12:12 AM 108 PART I Introduction to Economics 4.2 LEARNING OBJECTIVE Analyze the economic impact of an oil import tariff (tax). ◂▸ FIGURE 4.5 The U.S. Market for Crude Oil, 2012 In 2012 the world market price for crude oil was approximately $80 per barrel. Domestic production in the United States that year averaged about 7 million barrels per day, whereas crude oil demand averaged just under 13 million barrels per day. The difference between production and consumption were made up of net imports of approximately 6 million barrels per day, as we see in panel (a). If the government imposed a tax in this market of 33.33 percent, or $26.64, that would increase the world price to $106.64. That higher price causes quantity demanded to fall below its original level of 13 million barrels, while the price increase causes domestic production to rise above the original level. As we see in panel (b), the effect is a reduction in import levels. Many states have much higher minimum wages; California, for example, had a minimum wage in 2018 of $11.00 per hour. Critics of the minimum wage argue that if the minimum wage is effective and holds wages at a level higher than the market would produce, that rule will also result in less labor hired. While most economists agree that there will be some loss in jobs from a minimum wage, there is wide dispute on whether this effect is large or small. Supply and Demand Analysis: Tariffs (Tax) The basic logic of supply and demand is a powerful tool of analysis. As an extended example of the power of this logic, we will consider a proposal to impose a tax on goods produced outside the country, often called a tariff. In the first years of the Trump administration, there was considerable debate on whether or not the United States should impose tariffs
on foreign goods, in part as a way to help domestic producers. The tools we have learned thus far will show us the effects of tariffs, using the example of a tax on foreign oil. The United States imports a little more than half of the oil it consumes. Of the imports, a substantial portion comes from the Persian Gulf States. Given the political volatility of that area of the world, many politicians have for some years advocated trying to reduce our dependence on foreign oil. One tool often suggested by both politicians and economists to accomplish this goal has been an import oil tax or tariff. Supply and demand analysis makes the arguments of the import tax proponents easier to understand. Figure 4.5(a) shows the U.S. market for oil in a recent year. The world price of oil is a. U.S. market, 2012 P Supply US ) $ ( e c i r P 80 0 P A B World price Demand US 7 13 Q Imports = 6 Millions of barrels of crude oil per day b. Effects of an oil import fee in the United States Supply US ) $ ( e c i r P $26.64 Oil import fee 106.64 80 C D A B Demand US 0 7 Qc Qd13 Q Imports MyLab Economics Concept Check M04_CASE3826_13_GE_C04.indd 108 17/04/19 12:12 AM The Price Mechanism at Work for Shakespeare CHAPTER 4 Demand and Supply Applications 109 Every summer, New York City puts on free performances of Shakespeare in the Park. Tickets are distributed on a firstcome-first-serve basis at the Delacorte Theater in the park beginning at 1:00 pm on the day of the show. People usually begin lining up at 6:00 am when the park opens; by 10:00 am the line has typically reached a length sufficient to give away all available tickets. When you examine the people standing in line for these tickets, most of them seem to be fairly young. Many carry book bags identifying them as students in one of New York’s many colleges. Of course, all college students may be fervent Shakespeare fans, but can you think of another reason for the composition of the line? Further, when you attend one of the plays and look around, the audience appears much older and much sleeker than the people who were standing in line. What is going on? Although the tickets are “free” in terms of financial costs, their true price includes the
value of the time spent standing in line. Thus, the tickets are cheaper for people (for example, students) whose time value is lower than they are for high-wage earners, like an investment banker from Goldman Sachs. The true cost of a ticket is $0 plus the opportunity cost of the time spent in line. If the average person spends four hours in line, as is done in the Central Park case, for someone with a high wage, the true cost of the ticket might be very high. For example, a lawyer who earns $300 an hour would be giving up $1,200 to wait in line. It should not surprise you to see more people waiting in line for whom the tickets are inexpensive. What about the people who are at the performance? Think about our discussion of the power of entrepreneurs. In this case, the students who stand in line as consumers of the tickets also can play a role as producers. In fact, the students can produce tickets relatively cheaply by waiting in line. They can then turn around and sell those tickets to the high-wage Shakespeare lovers. These days eBay is a great source of tickets to free events, sold by individuals with low opportunity costs of their time who queued up. Craigslist even provides listings for people who are willing to wait in line for you. Of course, now and again we do encounter a busy businessperson in one of the Central Park lines. Recently, one of the authors encountered one and asked him why he was waiting in line rather than using eBay, and he replied that it reminded him of when he was young, waiting in line for rock concerts. CRITICAL THINKING 1. Many museums offer free admission one day a week, on a weekday. On that day we observe that museumgoers are more likely to be senior citizens than on a typical Saturday. Why? at slightly more than $80, and the United States is assumed to be able to buy all the oil that it wants at this price. This means that domestic producers cannot charge any more than $80 per barrel. The curve labeled Supply US shows the amount that domestic suppliers will produce at each price level. At a price of $80, domestic production is 7 million barrels per day. U.S. producers will produce at point A on the supply curve. The total quantity of oil demanded in the United States currently is approximately 13 million barrels per day. At a price of $80, the quantity demanded in the United States is point B on the demand curve. The difference between the total quantity
demanded (13 million barrels per day) and do- mestic production (7 million barrels per day) is total imports (6 million barrels per day). Now suppose that the government levies a tax of 33⅓ percent on imported oil. Because the import price is $80, this tax rate translates into a tax of $26.64, which increases the price per barrel paid by U.S. importers to $106.64 ($80 + $26.64). This new, higher price means that U.S. producers can also charge up to $106.64 for a barrel of crude. Note, however, that the tax is paid only on imported oil. Thus, the entire 106.64 paid for domestic crude goes to domestic producers. This should help you understand why domestic producers are often in favor of tariffs on foreign competitors; these tariffs raise the prices they can charge. M04_CASE3826_13_GE_C04.indd 109 17/04/19 12:12 AM 110 PART I Introduction to Economics Figure 4.5(b) shows the result of the tax. First, because of a higher price, the quantity demanded drops. People buy less oil. This is a movement along the demand curve from point B to point D. At the same time, the quantity supplied by domestic producers increases. This is a movement along the supply curve from point A to point C. With an increase in domestic quantity supplied and a decrease in domestic quantity demanded, imports decrease, as we can see clearly as Qd–Qc is smaller than the original 6 billion barrels per day. With domestic oil producers producing more oil, there may be more domestic workers hired in this industry. The tax also generates revenues for the federal government. The total tax revenue collected is equal to the tax per barrel ($26.64) times the number of imported barrels (Qd–Qc). What does all of this mean? In the final analysis, an oil import fee increases domestic production, reduces imports, and reduces overall consumption. Prices in the United States would rise, resulting for example in higher gas prices for cars and heating. Whether you are in favor of an oil tariff or not, you can see, depends on how you weigh these various factors. When we look at the oil market, some people, including many economists, believe that for environmental reasons, as a nation we should consume less oil than we currently do. We will discuss this topic at length in Chapter 16. If this is true
, then the higher domestic price for oil might not be a negative. In the case of many other goods for which tariffs might be contemplated, reduced consumption and higher prices may well be unwelcome. In 2018, the administration indicated it would put tariffs on foreign steel, another good that the United States imports in significant amounts. You should now be able to see the likely effect of such tariffs. More steel would be produced in the United States, improving the position of the owners of U.S. steel manufacturers and domestic steel workers. Steel prices would rise. But steel is used to produce cars and build buildings. So a price rise in steel would likely increase the costs of car manufacturers, hurting car consumers, auto workers, and auto manufacturers. Building costs and building prices would also rise. For a product like steel, the full effects of a tariff are complicated, but supply and demand analysis is very powerful in helping us to understand the full effects of a change in policy. 4.3 LEARNING OBJECTIVE Explain how consumer and producer surplus are generated. Supply and Demand and Market Efficiency Clearly, supply and demand curves help explain the way that markets and market prices work to allocate scarce resources. Recall that when we try to understand “how the system works,” we are doing “positive economics.” Supply and demand curves can also be used to illustrate the idea of market efficiency, an important aspect of “normative economics.” To understand the ideas, you first must understand the concepts of consumer and producer surplus. Consumer Surplus MyLab Economics Concept Check If we think hard about the lessons of supply and demand, we can see that the market forces us to reveal a great deal about our personal preferences. If you are free to choose within the constraints imposed by prices and your income and you decide to buy a hamburger for $2.50, you have “revealed” that a hamburger is worth at least $2.50 to you. Consumers reveal who they are by what they choose to buy and do. This idea of purchases as preference revelation underlies a lot of the valuation economists do. Look at the demand curve in Figure 4.6(a). At the current market price of $2.50, consumers will purchase 7 million hamburgers per month. In this market, consumers who value a hamburger at $2.50 or more will buy it, and those who have lower values will do without. As the figure shows, however, some people value hamburgers at more
than $2.50. At a price of $5.00, for example, consumers would still buy 1 million hamburgers. These million hamburgers have a value to their buyers of $5.00 each. If consumers can buy these burgers for only $2.50, they would earn a consumer surplus of $2.50 per burger. Consumer surplus is the difference between the maximum amount a person is willing to pay for a good and its current market price. The consumer surplus earned by the people willing to pay $5.00 for a hamburger is approximately equal to the shaded area between point A and the price, $2.50. consumer surplus The difference between the maximum amount a person is willing to pay for a good and its current market price. M04_CASE3826_13_GE_C04.indd 110 17/04/19 12:12 AM a. A simple market demand curve for hamburgers 5.00.50.50 CHAPTER 4 Demand and Supply Applications 111 b. Consumer surplus A B C Total consumer surplus at price $2.50 Millions of hamburgers per month MyLab Economics Concept Check Millions of hamburgers per month ◂▴ FIGURE 4.6 Market Demand and Consumer Surplus As illustrated in Figure 4.6(a), some consumers (see point A) are willing to pay as much as $5.00 each for hamburgers. Since the market price is just $2.50, they receive a consumer surplus of $2.50 for each hamburger that they consume. Others (see point B) are willing to pay something less than $5.00 and receive a slightly smaller surplus. Because the market price of hamburgers is just $2.50, the area of the shaded triangle in Figure 4.6(b) is equal to total consumer surplus. The second million hamburgers in Figure 4.6(a) are valued at more than the market price as well, although the consumer surplus gained is slightly less. Point B on the market demand curve shows the maximum amount that consumers would be willing to pay for the second million hamburgers. The consumer surplus earned by these people is equal to the shaded area between B and the price, $2.50. Similarly, for the third million hamburgers, maximum willingness to pay is given by point C; consumer surplus is a bit lower than it is at points A and B, but it is still
significant. The total value of the consumer surplus suggested by the data in Figure 4.6(a) is roughly equal to the area of the shaded triangle in Figure 4.6(b). To understand why this is so, think about offering hamburgers to consumers at successively lower prices. If the good were actually sold for $2.50, those near point A on the demand curve would get a large surplus; those at point B would get a smaller surplus. Those at point E would get no surplus. Producer Surplus MyLab Economics Concept Check Similarly, the supply curve in a market shows the amount that firms willingly produce and supply to the market at various prices. Presumably it is because the price is sufficient to cover the costs or the opportunity costs of production and give producers enough profit to keep them in business. When speaking of cost of production, we include everything that a producer must give up to produce a good. A simple market supply curve like the one in Figure 4.7(a) illustrates this point quite clearly. At the current market price of $2.50, producers will produce and sell 7 million hamburgers. There is only one price in the market, and the supply curve tells us the quantity supplied at each price. Notice, however, that if the price were just $0.75 (75 cents), although production would be much lower—most producers would be out of business at that price—a few producers would actually be supplying burgers. In fact, producers would supply about 1 million burgers to the market. These firms must have lower costs: They are more efficient or they have access to raw beef at a lower price or perhaps they can hire low-wage labor. If these efficient, low-cost producers are able to charge $2.50 for each hamburger, they are earning what is called a producer surplus. Producer surplus is the difference between the current market producer surplus The difference between the current market price and the cost of production for the firm. M04_CASE3826_13_GE_C04.indd 111 17/04/19 12:12 AM 112 PART I Introduction to Economics a. A simple market supply curve for hamburgers.50 ) $ ( e c i r P 2.50 0.75 C B A b. Producer surplus Total producer surplus at price $2.50 Millions of hamburgers per month MyLab Economics Concept Check Millions of hamburgers per month ◂▴ FIGURE 4.7 Market Supply and Producer
Surplus As illustrated in Figure 4.7(a), some producers are willing to produce hamburgers for a price of $0.75 each. Because they are paid $2.50, they earn a producer surplus equal to $1.75. Other producers are willing to supply hamburgers at prices less than $2.50, and they also earn producers surplus. Because the market price of hamburgers is $2.50, the area of the shaded triangle in Figure 4.7(b) is equal to total producer surplus. price and the cost of production for the firm. The first million hamburgers would generate a producer surplus of $2.50 minus $0.75, or $1.75 per hamburger: a total of $1.75 million. The second million hamburgers would also generate a producer surplus because the price of $2.50 exceeds the producers’ total cost of producing these hamburgers, which is above $0.75 but much less than $2.50. The total value of the producer surplus received by producers of hamburgers at a price of $2.50 per burger is roughly equal to the shaded triangle in Figure 4.7(b). Those producers just able to make a profit producing burgers will be near point E on the supply curve and will earn very little in the way of surplus. Competitive Markets Maximize the Sum of Producer and Consumer Surplus MyLab Economics Concept Check In the preceding example, the quantity of hamburgers supplied and the quantity of hamburgers demanded are equal at $2.50. Figure 4.8 shows the total net benefits to consumers and producers resulting from the production of 7 million hamburgers. Consumers receive benefits in excess of the price they pay and equal to the blue shaded area between the demand curve and the price line ◂▸ FIGURE 4.8 Total Producer and Consumer Surplus Total producer and consumer surplus is greatest where supply and demand curves intersect at equilibrium.50 Millions of hamburgers per month MyLab Economics Concept Check M04_CASE3826_13_GE_C04.indd 112 17/04/19 12:12 AM a. Deadweight loss from underproduction b. Deadweight loss from overproduction CHAPTER 4 Demand and Supply Applications 113 ) $ ( e c i r P 3.75 2.50 1.50 A B Deadweight loss.50 D Deadweight loss 10 Q Millions of hamburgers per month My
Lab Economics Concept Check Millions of hamburgers per month ◂▴ FIGURE 4.9 Deadweight Loss Figure 4.9(a) shows the consequences of producing 4 million hamburgers per month instead of 7 million hamburgers per month. Total producer and consumer surplus is reduced by the area of triangle ABC shaded in yellow. This is called the deadweight loss from underproduction. Figure 4.9(b) shows the consequences of producing 10 million hamburgers per month instead of 7 million hamburgers per month. As production increases from 7 million to 10 million hamburgers, the full cost of production rises above consumers’ willingness to pay, resulting in a deadweight loss equal to the area of triangle ABC. at $2.50; the area is equal to the amount of consumer surplus being earned. Producers receive compensation in excess of costs and equal to the red-shaded area between the supply curve and the price line at $2.50; the area is equal to the amount of producer surplus being earned. Now consider the result to consumers and producers if production were to be reduced to 4 million burgers. Look carefully at Figure 4.9(a). At 4 million burgers, consumers are willing to pay $3.75 for hamburgers and there are firms whose costs make it worthwhile to supply at a price as low as $1.50, yet something is stopping production at 4 million. The result is a loss of both consumer and producer surplus. You can see in Figure 4.9(a) that if production were expanded from 4 million to 7 million, the market would yield more consumer surplus and more producer surplus. The total loss of producer and consumer surplus from underproduction and, as we will see shortly, from overproduction is referred to as a deadweight loss. In Figure 4.9(a) the deadweight loss is equal to the area of triangle ABC shaded in yellow. Figure 4.9(b) illustrates how a deadweight loss of both producer and consumer surplus can result from overproduction as well. For every hamburger produced above 7 million, consumers are willing to pay less than the cost of production. The cost of the resources needed to produce hamburgers above 7 million exceeds the benefits to consumers, resulting in a net loss of producer and consumer surplus equal to the yellow shaded area ABC. If the government forced producers to increase hamburger production to 10 million units per month, society would lose value equal to the yellow triangle to the right
of point A in Figure 4.9(b). Potential Causes of Deadweight Loss from Under- and Overproduction MyLab Economics Concept Check Most of the next few chapters will discuss perfectly competitive markets in which prices are determined by the free interaction of supply and demand. As you will see, when supply and demand interact freely, competitive markets produce what people want at the least cost, that is, they are efficient. Beginning in Chapter 13, however, we will begin to relax assumptions and will discover a number of naturally occurring sources of market failure. Monopoly power gives firms the incentive to underproduce and overprice, taxes and subsidies may distort consumer deadweight loss The total loss of producer and consumer surplus from underproduction or overproduction. M04_CASE3826_13_GE_C04.indd 113 17/04/19 12:12 AM 114 PART I Introduction to Economics choices, external costs such as pollution and congestion may lead to over- or underproduction of some goods, and artificial price floors and price ceilings may have the same effects. Looking Ahead We have now examined the basic forces of supply and demand and discussed the market/ price system. These fundamental concepts will serve as building blocks for what comes next. Whether you are studying microeconomics or macroeconomics, you will be studying the functions of markets and the behavior of market participants in more detail in the following chapters. Because the concepts presented in the first four chapters are so important to your under- standing of what is to come, this might be a good time for you to review this material. S U M M A R Y 4.1 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES p. 101 1. In a market economy, the market system (or price system) serves two functions. It determines the allocation of resources among producers and the final mix of outputs. It also distributes goods and services on the basis of willingness and ability to pay. In this sense, it serves as a price rationing device. 2. Governments as well as private firms sometimes decide not to use the market system to ration an item for which there is excess demand. Examples of nonprice rationing systems include queuing, favored customers, and ration coupons. The most common rationale for such policies is “fairness.” 3. Attempts to bypass the market and use alternative nonprice rationing devices are more difficult and costly than it would seem at first glance. Schemes that open up opportunities for favored customers
, black markets, and side payments often end up less “fair” than the free market. A supply curve shows the relationship between the quantity producers are willing to supply to the market and the price of a good. 4.2 SUPPLY AND DEMAND ANALYSIS: TARIFFS (TAX) p. 108 4. The basic logic of supply and demand is a powerful tool for analysis. For example, supply and demand analysis shows that an oil import tax will reduce quantity of oil demanded, increase domestic production, and generate revenues for the government. 4.3 SUPPLY AND DEMAND AND MARKET EFFICIENCY p. 110 5. Supply and demand curves can also be used to illustrate the idea of market efficiency, an important aspect of normative economics. 6. Consumer surplus is the difference between the maximum amount a person is willing to pay for a good and the current market price. 7. Producer surplus is the difference between the current market price and the cost of production for the firm. 8. At free market equilibrium with competitive markets, the sum of consumer surplus and producer surplus is maximized. 9. The total loss of producer and consumer surplus from underproduction or overproduction is referred to as a deadweight loss black market, p. 105 consumer surplus, p. 110 deadweight loss, p. 113 favored customers, p. 104 minimum wage, p. 107 price ceiling, p. 103 price floor, p. 107 price rationing, p. 101 producer surplus, p. 111 queuing, p. 103 ration coupons, p. 104 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M04_CASE3826_13_GE_C04.indd 114 17/04/19 12:12 AM CHAPTER 4 Demand and Supply Applications 115 P R O B L E M S All problems are available on MyLab Economics. 4.1 THE PRICE SYSTEM: RATIONING AND ALLOCATING RESOURCES LEARNING OBJECTIVE: Understand how price floors and price ceilings work in the market place. 1.1 Illustrate the following with supply and demand curves: a. In November 2018, Edward Hopper’s iconic painting Chop Suey was sold for $91.9 million at the British auction house Christie’s. b. In August 2015, the Global Dairy
Trade (GDT) Price Index was 514, down from 880 a year before. This was primarily due to the fact that supply had increased during this period. c. In 2017, the global demand for solar photovoltaic (PV) power was about 85 gigawatts. Its contribution to total electricity generation grew from 0.01 percent in 2004 to 0.79 percent in 2014, increasing the number of solar power plants during this period. The overall result was a drop in the average cost of solar power and an increase in the amount of electricity generated from $500 per megawatt hour (MWh) in 2010 to $200 per MWh in 2015. 1.2 Every demand curve must eventually hit the quantity axis because with limited incomes, there is always a price so high that there is no demand for the good. Do you agree or disagree? Why? 1.3 When excess demand exists for tickets to a major sporting event or a concert, profit opportunities exist for scalpers. Explain briefly using supply and demand curves to illustrate. Some argue that scalpers work to the advantage of everyone and are “efficient.” Do you agree or disagree? Explain briefly. 1.4 In an effort to “support” the price of raw milk and dairy products, some dairy farmers advocate a cash subsidy for every cow that is left unused. They argue that the subsidy increases the cost of dairy farming, reduces supply, and increases the price of competitor’s dairy products. Critics argue that because the subsidy is a payment to dairy farmers, it will reduce costs and lead to lower prices. Which argument is correct? Explain. 1.5 Between 2015 and 2018, the average monthly rent doubled in Budapest. On average, the real estate rent increased from 130 thousand Hungarian forint or Ft (€420) per month in 2017 to 140 thousand Ft (€450) in 2018. At the same time, a large number of condos are being built across the Hungarian capital. How is this possible? 1.6 Illustrate the following with supply or demand curves: a. In 2017, the Motiva refinery at Port Arthur, Texas, was forced to shut down due to Hurricane Harvey. It was the largest refinery in the United States. Along with Motiva, other refineries in the area were also shut down, accounting for almost 20 percent of the country’s capacity. Which way would you expect the price of oil to go? b. A sudden frost during the spring season leads to a large number
of cherry trees to lose their flowers. Which way will the price of cherries go? c. In 2018, the United Kingdom witnessed one of the hottest summers according to the Met Office. The average temperature was 15.8°C (60.4°F), similar to what it was in 1976, 2003, and 2006. With Britain in a prolonged period of heat, mobile air conditioners gained popularity. Which way will the price of air conditioners go? 1.7 Illustrate the following with supply or demand curves: a. A situation of excess demand for medicine in China before June 1, 2015, caused by a price cap on most drugs. b. The effect of a sharp decrease in poultry feed prices on the demand for other meat produce. 1.8 Uber, the peer-to-peer ridesharing and transportation company, has a price hike mechanism called “surge pricing,” which causes the minimum fare and per-kilometer fare to increase above the normal level. For example, in India, Uber drivers agree that the maximum multiple is 1.2 x, which means a 20 percent “surge” in fares. Assume that the average number of passengers per hour is 20. During rush hour in New Delhi, the number of passengers increases to 100 per hour. Consequently, Uber drivers raise the fares by 20 percent. If the fare increases, what will happen to demand? Illustrate with supply and demand curves. 1.9 In 2008, an ounce of gold was worth about $750, while as of September 2011 it was around $1,800. What are the causes for such a rise in price? How has the price of gold changed since then? 1.10 Many cruise lines offer 5-day trips. A disproportionate number of these trips leave port on Thursday and return late Monday. Why might this be true? 1.11 [Related to the Economics in Practice on p. 109] Lines for free tickets to see free Shakespeare in Central Park are often long. A local politician has suggested that it would be a great service if the park provided music to entertain those who are waiting in line. What do you think of this suggestion? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M04_CASE3826_13_GE_C04.indd 115 17/04/19 12:12 AM 116
PART I Introduction to Economics 1.12 The following graph represents the market for wheat. The equilibrium price is $20 per bushel and the equilibrium quantity is 14 million bushels. Price of wheat (bushel) 30 20 10 0 Supply 2 4 68 1 0 12 14 16 18 20 22 24 26 Demand much will be imported? Illustrate total imports on your graph of the U.S. oil market. c. Suppose the United States imposes a tariff of $5 per barrel on imported oil. What quantity would Americans buy? How much of this would be supplied by American producers? How much would be imported? How much tariff revenue would the government collect? d. Briefly summarize the impact of an oil tariff by explaining who is helped and who is hurt among the following groups: domestic oil consumers, domestic oil producers, foreign oil producers, and the U.S. government. 2.2 Use the data in the preceding problem to answer the fol- lowing questions. Now suppose that the United States allows no oil imports. a. What are the equilibrium price and quantity for oil in the United States? b. If the United States imposed a price ceiling of $65 per barrel on the oil market and prohibited imports, would there be an excess supply or an excess demand for oil? If so, how much? c. Under the price ceiling, quantity supplied and quantity demanded differ. Which of the two will determine how much oil is purchased? Briefly explain why. Quantity of wheat (millions of bushels) 4.3 SUPPLY AND DEMAND AND MARKET EFFICIENCY LEARNING OBJECTIVE: Explain how consumer and producer surplus are generated. a. Explain what will happen if the government establishes a price ceiling of $10 per bushel of wheat in this market? What if the price ceiling was set at $30? b. Explain what will happen if the government establishes a price floor of $30 per bushel of wheat in this market. What if the price floor was set at $10? 4.2 SUPPLY AND DEMAND ANALYSIS: TARIFFS (TAX) LEARNING OBJECTIVE: Analyze the economic impact of an oil import tariff (tax). 2.1 Suppose that the world price of oil is $60 per barrel and that the United States can buy all the oil it wants at this price. Suppose also that the demand and supply schedules for oil in the United States are as follows: Price ($ Per Barrel) U.
S. Quantity Demanded U.S. Quantity Supplied 55 60 65 70 75 26 24 22 20 18 14 16 18 20 22 a. On graph paper, draw the supply and demand curves for the United States. b. With free trade in oil, what price will Americans pay for their oil? What quantity will Americans buy? How much of this will be supplied by American producers? How 3.1 Use the following diagram to calculate total consumer surplus at a price of $12 and production of 500,000 flu vaccinations per day. For the same equilibrium, calculate total producer surplus. Assuming the price remained at $12, but production was cut to 200,000 vaccinations per day, calculate producer surplus and consumer surplus. Calculate the deadweight loss from underproduction 24 20 16 12 8 4 S D 100 200 300 400 500 600 700 800 900 0 Thousands of vaccinations per day 3.2 Suppose the market demand for a cup of cappuccino is given by QD = 24 - 4P and the market supply for a cup of cappuccino is given by QS = 8P - 12, where P = price (per cup). a. Graph the supply and demand schedules for cappuccino. b. What is the equilibrium price and equilibrium quantity? c. Calculate consumer surplus and producer surplus, and identify these on the graph. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M04_CASE3826_13_GE_C04.indd 116 17/04/19 12:12 AM CHAPTER 4 Demand and Supply Applications 117 a. Find the values of consumer surplus and producer surplus when the market is in equilibrium, and identify these areas on the graph. b. If underproduction occurs in this market, and only 9 million DVDs are produced, what happens to the amounts of consumer surplus and producer surplus? What is the value of the deadweight loss? Identify these areas on the graph. c. If overproduction occurs in this market, and 27 million DVDs are produced, what happens to the amounts of consumer surplus and producer surplus? Is there a deadweight loss with overproduction? If so, what is its value? Identify these areas on the graph. 3.3 In September 2017, Uber lost its license to operate in London on grounds of lack of corporate responsibility, disregard for local rules, and noncompliance
to tax laws. In 2018, the company began its appeal in London to reverse the decision and reinstate its operating license. Explain how the ban on Uber affects consumer surplus and producer surplus in the city, and show these changes graphically. 3.4 The following graph represents the market for DVDs. Price of DVDs 7 6 5 4 3 2 1 0 Supply Demand Quantity of DVDs (millions) 3 6 9 12 15 18 21 24 27 30 QUESTION 1 The State of Florida has a price gouging law that prohibits raising prices after a hurricane or other natural disaster. When hurricanes pass, the supply chains for many goods are disrupted. Explain how the state’s price gouging law affect the market for these goods. QUESTION 2 Suppose that you got up early this morning to buy a concert ticket for your favorite band. You had to log in to their website and wait in a queue for 20 minutes to access the online sale, but you were ultimately successful in buying two tickets for $45 each. The show sold out minutes later. What is the true cost of attending the concert? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M04_CASE3826_13_GE_C04.indd 117 17/04/19 12:12 AM PA RT II CONCEPTS AND PROBLEMS IN MACROECONOMICS 5 Introduction to Macroeconomics CHAPTER OUTLINE AND LEARNING OBJECTIVES 5.1 Macroeconomic Concerns p. 119 Describe the primary three concerns of macroeconomics. 5.2 The Components of the Macroeconomy p. 122 Discuss the interaction between the four components of the macroeconomy. 5.3 A Brief History of Macroeconomics p. 125 Summarize the macroeconomic history of the United States between 1929 and 1970. 5.4 The U.S. Economy since 1970 p. 127 Describe the U.S. economy since 1970. microeconomics The branch of economics that examines the functioning of individual industries and the behavior of individual decision-making units—that is, firms and households. macroeconomics The branch of economics that examines the economic behavior of aggregates—income, employment, output, and so on—on a national scale. 118118 When the macroeconomy is doing well, jobs are easy to find, incomes are generally rising, and profits of
corporations are high. On the other hand, if the macroeconomy is in a slump, new jobs are scarce, incomes are not growing well, and profits are low. Students who entered the job market in the boom of the late 1990s in the United States, on average, had an easier time finding a job than did those who entered in the recession of 2008–2009. The slow growth after the recession had negative effects on millions of people, although by 2017 unemployment had substantially fallen and job prospects were much improved. Given the large effect that the macroeconomy can have on our lives, it is important that we understand how it works. We begin by discussing the differences between microeconomics and macroeconomics that we glimpsed in Chapter 1. Microeconomics examines the functioning of individual industries and the behavior of individual decision-making units, typically firms and households. With a few assumptions about how these units behave (firms maximize profits; households maximize utility), we can derive useful conclusions about how markets work and how resources are allocated. Instead of focusing on the factors that influence the production of particular products and the behavior of individual industries, macroeconomics focuses on the determinants of total national output. Macroeconomics studies not household income but national income, not individual prices but the overall price level. It does not analyze the demand for labor in the automobile industry but instead total employment in the economy. Both microeconomics and macroeconomics are concerned with the decisions of households and firms. Microeconomics deals with individual decisions; macroeconomics deals with the sum of these individual decisions. Aggregate is used in macroeconomics to refer to sums. When we speak of aggregate behavior, we mean the behavior of all households as well as the behavior of all firms. We also speak of aggregate consumption and aggregate investment, which refer to total consumption and total investment in the economy, respectively. M05_CASE3826_13_GE_C05.indd 118 17/04/19 12:04 PM CHAPTER 5 Introduction to Macroeconomics 119 Because microeconomists and macroeconomists look at the economy from different perspectives, you might expect that they would reach somewhat different conclusions about the way the economy behaves. This is true to some extent. Microeconomists generally conclude that markets work well. They see prices as flexible, adjusting to maintain equality between quantity supplied and quantity demanded. Macroeconomists, however, observe that important prices in the economy—for example, the wage rate (or price of labor)—often
seem “sticky.” Sticky prices are prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. Microeconomists do not expect to see the quantity of apples supplied exceeding the quantity of apples demanded because the price of apples is not sticky. On the other hand, macroeconomists—who analyze aggregate behavior—examine periods of high unemployment, where the quantity of labor supplied appears to exceed the quantity of labor demanded. At such times, it appears that wage rates do not fall fast enough to equate the quantity of labor supplied and the quantity of labor demanded. aggregate behavior The behavior of all households and firms together. sticky prices Prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. Macroeconomic Concerns Three of the major concerns of macroeconomics are ■■ Output growth ■■ Unemployment ■■ Inflation and deflation 5.1 LEARNING OBJECTIVE Describe the three primary concerns of macroeconomics. Government policy makers would like to have high output growth, low unemployment, and low inflation. We will see that these goals may conflict with one another and that an important point in understanding macroeconomics is understanding these conflicts. Output Growth MyLab Economics Concept Check Instead of growing at an even rate at all times, economies tend to experience short-term ups and downs in their performance. The technical name for these ups and downs is the business cycle. The main measure of how an economy is doing is aggregate output, the total quantity of goods and services produced in the economy in a given period. When less is produced (in other words, when aggregate output decreases), there are fewer goods and services to go around and the average standard of living declines. When firms cut back on production, they also lay off workers, increasing the rate of unemployment. A typical business cycle is illustrated in Figure 5.1. Because most economies, on average, grow over time, the business cycle in Figure 5.1 shows a positive trend—the peak (the highest point) of a new business cycle is higher than the peak of the previous cycle. The period business cycle The cycle of short-term ups and downs in the economy. aggregate output The total quantity of goods and services produced in an economy in a given period. Peak R e c e s si o B n Trough Trend growth xpansion Trough ▴ FIGURE 5.1 A Typical Business Cycle In this business cycle, the economy is expanding as it moves through point A from the trough to the peak. When
the economy moves from a peak down to a trough, through point B, the economy is in recession. Time MyLab Economics Concept Check M05_CASE3826_13_GE_C05.indd 119 17/04/19 12:04 PM 120 PART II Concepts and Problems in Macroeconomics expansion or boom The period in the business cycle from a trough up to a peak during which output and employment grow. contraction, recession, or slump The period in the business cycle from a peak down to a trough during which output and employment fall. depression A prolonged and deep recession. 17,000 14,000 11,000 8,000 6,000 4,000 2,000 1,000 from a trough, or bottom of the cycle, to a peak is called an expansion or a boom. During an expansion, output and employment grow. The period from a peak to a trough is called a contraction, recession, or slump, when output and employment fall. A prolonged and deep recession is called a depression, although economists do not agree on when a recession becomes a depression. Since the 1930s the United States has experienced one depression (during the 1930s) and eight recessions: 1946, 1954, 1958, 1974–1975, 1980–1982, 1990–1991, 2001, and 2008–2009. Other countries also experienced recessions in the twentieth century, some roughly coinciding with U.S. recessions and some not. In judging whether an economy is expanding or contracting, note the difference between the level of economic activity and its rate of change. If the economy has just left a trough (point A in Figure 5.1), it will be growing (rate of change is positive), but its level of output will still be low. If the economy has just started to decline from a peak (point B), it will be contracting (rate of change is negative), but its level of output will still be high. The business cycle drawn in Figure 5.1 is symmetrical, which means that the length of an expansion is the same as the length of a contraction. Most business cycles are not symmetrical, however. It is possible, for example, for the expansion phase to be longer than the contraction phase. When contraction comes, it may be fast and sharp, whereas expansion may be slow and gradual. Moreover, the economy is not nearly as regular as the business cycle in Figure 5.1 indicates. The ups and downs in the economy tend to be erratic. Figure 5.2 shows the
actual business cycles in the United States between 1900 and 2017. Although many business cycles have occurred in the last 118 years, each is unique. The economy is not so simple that it has regular cycles. The periods of the Great Depression and World War I and II show the largest fluctuations in Figure 5.2, although other large contractions and expansions have taken place. Note the expansion in the 1960s and the five recessions since 1970. Some of the cycles have been long; some have been short. Note also that aggregate output actually increased in the Depression years between 1933 and 1937, even though it was still quite low in 1937. The economy did not fully come out of the Depression until the defense buildup prior to the start of World War II. Note also that business cycles were more extreme before World War II than they have been since then. We will explore the role of government institutions in moderating the business cycle. Finally, note that the recovery from the 2008–2009 recession was unusually slow. Recession 2008–2009 Recession 1980–1982 Recession 1974–1975 Vietnam War Second oil shock First oil shock Recession 2001 Recession 1990–1991 Korean War World War II Roaring Twenties World War I The Great Depression 300 1900 1910 1920 1930 1940 1950 1960 Years 1970 1980 2000 1990 2017 MyLab Economics Real-time data 2010 ▴ FIGURE 5.2 U.S. Aggregate Output (Real GDP), 1900–2017 The periods of the Great Depression and World War I and II show the largest fluctuations in aggregate output. M05_CASE3826_13_GE_C05.indd 120 17/04/19 12:04 PM CHAPTER 5 Introduction to Macroeconomics 121 Unemployment MyLab Economics Concept Check You cannot listen to the news or read a newspaper without hearing reports on the unemployment rate. The unemployment rate—the percentage of the labor force that is unemployed—is a key indicator of the economy’s health and is reported monthly by the government. Because the unemployment rate is usually closely related to the economy’s aggregate output, announcements of each month’s new figure are followed with great interest by economists, politicians, business people, and policy makers. Although macroeconomists are interested in learning why the unemployment rate has risen or fallen in a given period, they also try to answer a more basic question: Why is there any unemployment at all? Part of the answer to this question is straightforward, coming from the fact that adjustments in labor markets generally take some time. At times people decide to quit their
jobs and look for something better. Until they find a new job, they will be unemployed. At any time, some firms may go bankrupt because of competition from rivals, bad management, or bad luck. Employees of such firms typically are not able to find new jobs immediately, and while they are looking for work, they will be unemployed. Also, workers entering the labor market for the first time may require a few weeks or months to find a job. All of these factors tell us that some positive rate of unemployment is inevitable in a dynamic economy. A key question in macroeconomics is how the economy adjusts when the unemployment rate rises beyond this base level. Supply and demand analysis leads us to expect a market response to the existence of unemployed workers. Specifically, when there is unemployment beyond some minimum amount, there is an excess supply of workers—at the going wage rates, there are people who want to work who cannot find work. Microeconomic theory tells us that excess supply causes a decrease in the price of the commodity in question. As prices fall, quantity demanded rises and the quantity supplied falls. In the end prices fall enough so that quantity supplied equals the quantity demanded, and equilibrium is restored as the market clears. The existence of unemployment seems to contradict this story and to imply that the aggregate labor market is not in equilibrium—that something prevents the quantity supplied and the quantity demanded from equating. Why do labor markets not clear when other markets do, or is it that labor markets are clearing and the unemployment data reflect something different? This is one of the ongoing debates in macroeconomics. Inflation and Deflation MyLab Economics Concept Check Inflation is an increase in the overall price level. Keeping inflation low has long been a goal of government policy. Especially problematic are hyperinflations, or periods of very rapid increases in the overall price level. Most Americans are unaware of what life is like under high inflation. In some countries at some times, people were accustomed to prices rising by the day, by the hour, or even by the minute. During the hyperinflation in Bolivia in 1984 and 1985, the price of one egg rose from 3,000 pesos to 10,000 pesos in 1 week. In 1985, three bottles of aspirin sold for the same price as a luxury car had sold for in 1982. At the same time, the problem of handling money became a burden. Bolivia’s currency, printed in West Germany and England, was the country’s third biggest import in 1984, surpassed only by wheat
and mining equipment. In December 2017 the inflation rate in Venezuela reached 4,000 percent, and the country experienced numerous street protests against the policies of President Nicolas Maduro. In January 2018, prices in Venezuela were doubling every 35 days. Very high inflation can destabilize economies and governments. Hyperinflations are rare. Nonetheless, economists have devoted much effort to identifying the costs and consequences of even moderate inflation. Does anyone gain from inflation? Who loses? What costs does moderate inflation impose on society? What causes inflation? What is the best way to stop it? Here too we find debate. A decrease in the overall price level is called deflation. In some periods in U.S. history and recently in Japan, deflation has occurred over an extended period of time. In 2015 the European Union began to take steps to fight what was seen as the early stages of deflation in that region. The goal of policy makers is to avoid prolonged periods of deflation as well as inflation to pursue the macroeconomic goal of stability. unemployment rate The ratio of the number of people unemployed to the total number of people in the labor force. inflation An increase in the overall price level. hyperinflation A period of very rapid increases in the overall price level. deflation A decrease in the overall price level. M05_CASE3826_13_GE_C05.indd 121 17/04/19 12:04 PM 122 PART II Concepts and Problems in Macroeconomics 5.2 LEARNING OBJECTIVE Discuss the interaction among the four components of the macroeconomy. The Components of the Macroeconomy Understanding how the macroeconomy works can be challenging because a great deal is going on at one time. Everything seems to affect everything else. To see the big picture, it is helpful to divide the participants in the economy into four broad groups: (1) households, (2) firms, (3) the government, and (4) the rest of the world. Households and firms make up the private sector, the government is the public sector, and the rest of the world is the foreign sector. These four groups interact in the economy in a variety of ways, many involving either receiving or paying income. circular flow A diagram showing the flows in and out of the sectors in the economy. transfer payments Cash payments made by the government to people who do not supply goods, services, or labor in exchange for these payments. They include Social Security benefits, veterans’ benefits, and welfare payments. ▸ FIGURE 5.3
The Circular Flow of Payments Households receive income from firms and the government, purchase goods and services from firms, and pay taxes to the government. They also purchase foreign-made goods and services (imports). Firms receive payments from households and the government for goods and services; they pay wages, dividends, interest, and rents to households and taxes to the government. The government receives taxes from firms and households, pays firms and households for goods and services—including wages to government workers—and pays interest and transfers to households. Finally, people in other countries purchase goods and services produced domestically (exports). The Circular Flow Diagram MyLab Economics Concept Check A useful way of seeing the economic interactions among the four groups in the economy is a circular flow diagram, which shows the income received and payments made by each group. A simple circular flow diagram is pictured in Figure 5.3. Let us walk through the circular flow step by step. Households work for firms and the government, and they receive wages for their work. Our diagram shows a flow of wages into households as payment for those services. Households also receive interest on corporate and government bonds and dividends from firms. Many households receive other payments from the government, such as Social Security benefits, veterans’ benefits, and government assistance to the needy. Economists call these kinds of payments from the government (for which the recipients do not supply goods, services, or labor) transfer payments. Together, these receipts make up the total income received by the households. Households buy goods and services from firms and pay taxes to the government. These items make up the total amount paid out by the households. The difference between the total receipts and the total payments of the households is the amount that the households save or dissave. If households receive more than they spend, they save during the period. If they receive less than they spend, they dissave. A household can dissave by using up some of its previous savings or by borrowing. In the circular flow diagram, household spending is shown as a flow out o f theWorld of goods and services a d e byforeig n e rs ( e domestically m services of ses nd a a h s urc d o o P g P u r c hasesofgo a n d services o d P go urc axes s Firms Government Households Taxes W ages, int e r e s t, transfer pay m e n t s Wages,interest, dividends, MyLab Economics Concept Check M05
_CASE3826_13_GE_C05.indd 122 17/04/19 12:04 PM CHAPTER 5 Introduction to Macroeconomics 123 of households. Saving by households is sometimes termed a “leakage” from the circular flow because it withdraws income, or current purchasing power, from the system. Firms sell goods and services to households and the government earning revenue, which shows up in the circular flow diagram as a flow into the firm sector. Firms pay wages, interest, and dividends to households, and firms pay taxes to the government. These payments are shown flowing out of firms. The government collects taxes from households and firms. The government also makes payments. It buys goods and services from firms, pays wages and interest to households, and makes transfer payments to households. If the government’s revenue is less than its payments, the government is dissaving. Finally, households spend some of their income on imports—goods and services produced in the rest of the world. Similarly, people in foreign countries purchase exports—goods and services produced by domestic firms and sold to other countries. One lesson of the circular flow diagram is that everyone’s expenditure is someone else’s receipt. If you buy a personal computer from Dell, you make a payment to Dell, and Dell receives revenue. If Dell pays taxes to the government, it has made a payment and the government has received revenue. Everyone’s expenditures go somewhere. It is impossible to sell something without there being a buyer, and it is impossible to make a payment without there being a recipient. Every transaction must have two sides. The Three Market Arenas MyLab Economics Concept Check Another way of looking at the ways households, firms, the government, and the rest of the world relate to one another is to consider the markets in which they interact. We divide the markets into three broad arenas: (1) the goods-and-services market, (2) the labor market, and (3) the money (financial) market. Goods-and-Services Market Households and the government purchase goods and services from firms in the goods-and-services market. In this market, firms also purchase goods and services from each other. For example, Levi Strauss buys denim from other firms to make its blue jeans. In addition, firms buy capital goods from other firms. If Amazon needs new robots in its warehouses, it may buy them from another firm instead of making them itself. Apple, in constructing its
iPod, buys parts from a number of other firms. Firms supply to the goods-and-services market. Households, the government, and firms demand from this market. Finally, the rest of the world buys from and sells to the goods-and- services market. The United States imports hundreds of billions of dollars’ worth of automobiles, DVDs, oil, and other goods. In the case of Apple’s iPod, inputs come from other firms located in countries all over the world. At the same time, the United States exports hundreds of billions of dollars’ worth of computers, airplanes, and agricultural goods. Labor Market Interaction in the labor market takes place when firms and the government purchase labor from households. In this market, households supply labor and firms and the government demand labor. In the U.S. economy, firms are the largest demanders of labor, although the government is also a substantial employer. The total supply of labor in the economy depends on the sum of decisions made by households. Individuals must decide whether to enter the labor force (whether to look for a job at all) and how many hours to work. Labor is also supplied to and demanded from the rest of the world. In recent years, the labor market has become an international market. For example, vegetable and fruit farmers in California would find it difficult to bring their product to market if it were not for the labor of migrant farm workers from Mexico. Beginning in the 1960s. Turkey provided Germany with “guest workers” who were willing to take low-paying jobs unattractive to German workers. While the initial plan was for workers to stay a few years and then return to Turkey, many ended up staying in Germany but remained Turkish citizens. Call centers run by major U.S. corporations are sometimes staffed by labor in India and other developing countries. Money Market In the money market—sometimes called the financial market—households purchase stocks and bonds from firms. Households supply funds to this market in the expectation of M05_CASE3826_13_GE_C05.indd 123 17/04/19 12:04 PM 124 PART II Concepts and Problems in Macroeconomics Treasury bonds, notes, or bills Promissory notes issued by the federal government when it borrows money. in exchange for money. corporate bonds Promissory notes issued by corporations when they borrow money. shares of stock Financial instruments that give to the holder a share in the firm’s ownership and therefore the right
to share in the firm’s profits. dividend The portion of a firm’s profits that the firm pays out each period to its shareholders. fiscal policy The government’s spending and taxing policies. monetary policy The tools used by the Federal Reserve to control short term interest rates. earning income in the form of dividends on stocks and interest on bonds. Households also demand (borrow) funds from this market to finance various purchases. Firms borrow to build new facilities in the hope of earning more in the future. The government borrows by issuing bonds to fund public programs. Much of the borrowing and lending of households, firms, the government, and the rest of the world are coordinated by financial institutions—commercial banks, savings and loan associations, insurance companies, and the like. These institutions take deposits from one group and lend them to others, often moving funds from one part of the world to another. When a firm, a household, or the government borrows to finance a purchase, it has an obligation to pay that loan back, usually at some specified time in the future. Most loans also involve payment of interest as a fee for the use of the borrowed funds. When a loan is made, the borrower usually signs a “promise to repay,” or promissory note, and gives it to the lender. When the federal government borrows, it issues “promises” called Treasury bonds, notes, or bills. Firms can borrow from banks, or in the case of corporations, they can issue corporate bonds. Instead of issuing bonds to raise funds, corporations can also issue shares of stock. A share of stock is a financial instrument that gives the holder a share in the firm’s ownership and therefore the right to share in the firm’s profits. If the firm does well, the value of the stock increases and the stockholder receives a capital gain1 on the initial purchase. In addition, the stock may pay dividends—that is, the firm may return some of its profits directly to its stockholders instead of retaining the profits to buy capital. If the firm does poorly, so does the stockholder. The capital value of the stock may fall, and dividends may not be paid. Stocks are traded in exchanges in many parts of the world, with the largest exchanges located in New York, London, and Tokyo. Stocks and bonds are simply contracts, or agreements, between parties. I agree to loan you a certain amount, and you agree to repay me
this amount plus something extra at some future date, or I agree to buy part ownership in your firm, and you agree to give me a share of the firm’s future profits. A critical variable in the money market is the interest rate. Although we sometimes talk as if there is only one interest rate, there is never just one interest rate at any time. Instead, the interest rate on a given loan reflects the length of the loan and the perceived risk to the lender. A business that is just getting started must pay a higher rate than General Motors pays. A 30-year mortgage has a different interest rate than a 90-day loan. Nevertheless, interest rates tend to move up and down together, and their movement reflects general conditions in the financial market. The Role of the Government in the Macroeconomy MyLab Economics Concept Check The government plays a major role in the macroeconomy, so a useful way of learning how the macroeconomy works is to consider how the government uses policy to affect the economy. The two main policy instruments of the government are (1) fiscal policy and (2) monetary policy. Much of the study of macroeconomics is learning how fiscal and monetary policies work. Fiscal policy refers to the government’s decisions about how much to tax and spend. The federal government collects taxes from households and firms and spends those funds on goods and services ranging from missiles to parks to Social Security payments to interstate highways. Taxes take the form of personal income taxes, Social Security taxes, and corporate profits taxes, among others. An expansionary fiscal policy is a policy in which taxes are cut or government spending increases. A contractionary fiscal policy is the reverse. Monetary policy in the United States is conducted by the Federal Reserve, the nation’s central bank. The Fed, as it is usually called, controls short-term interest rates in the economy. The Fed’s decisions have important effects on the economy. In fact, the task of trying to smooth out business cycles in the United States has historically been left to the Fed (that is, to monetary policy). The chair of the Federal Reserve, currently Jerome Powell who replaced Janet Yellen in 2018, is sometimes said to be the second-most powerful person in the United States after the president. As we will see later in the text, the Fed played a more active role in the 2008–2009 recession than it had in previous recessions. Fiscal policy, however, also played an active role in the 2008–2009 recession and its aftermath
. 1A capital gain occurs whenever the value of an asset increases. If you bought a stock for $1,000 and it is now worth $1,500, you have earned a capital gain of $500. A capital gain is “realized” when you sell the asset. Until you sell, the capital gain is accrued but not realized. M05_CASE3826_13_GE_C05.indd 124 17/04/19 12:04 PM CHAPTER 5 Introduction to Macroeconomics 125 A Brief History of Macroeconomics The severe economic contraction and high unemployment of the 1930s, the decade of the Great Depression, spurred a great deal of thinking about macroeconomic issues, especially unemployment. Figure 5.2 shows that this period had the largest and longest aggregate output contraction in the twentieth century in the United States. The 1920s had been prosperous years for the U.S. economy. Virtually everyone who wanted a job could get one, incomes rose substantially and prices were stable. Beginning in late 1929, things took a sudden turn for the worse. In 1929, 1.5 million people were unemployed. By 1933, that had increased to 13 million out of a labor force of 51 million. In 1933, the United States produced about 27 percent fewer goods and services than it had in 1929. In October 1929, when stock prices collapsed on Wall Street, billions of dollars of personal wealth were lost. Unemployment remained above 14 percent of the labor force until 1940. (See the Economics in Practice, p. 126, “Macroeconomics in Literature,” for Fitzgerald’s and Steinbeck’s take on the 1920s and 1930s.) Before the Great Depression, economists applied microeconomic models, sometimes referred to as “classical” or “market clearing” models, to the overall economy. As we suggested, classical supply and demand analysis assumed that an excess supply of labor would drive down wages to a new equilibrium level. The decline in the wage rate would in turn raise the quantity of labor demanded by firms, erasing the unemployment. The prediction was clear: unemployment could not persist. But, during the Great Depression, unemployment levels remained high for nearly 10 years. In large measure, the failure of simple classical models to explain the prolonged existence of high unemployment provided the impetus for the development of macroeconomics. It is not surprising that what we now call macroeconomics was born in the 1930s. One of the most important works in
the history of economics, The General Theory of Employment, Interest and Money, by John Maynard Keynes, was published in 1936. Building on what was already understood about markets and their behavior, Keynes set out to construct a theory that would explain the confusing economic events of his time. Much of macroeconomics has roots in Keynes’s work. According to Keynes, it is not prices and wages alone that determine the level of employment, as classical models had suggested. The level of aggregate demand (sometimes called “total spending”) for goods and services also plays a role. Moreover, Keynes believed that governments could intervene in the economy and affect the level of output and employment. When private demand is low, Keynes argued, governments could stimulate aggregate demand and, by so doing, lift the economy out of recession. (Keynes was a larger-than-life figure, one of the Bloomsbury group in England that included, among others, Virginia Woolf and Clive Bell.) After World War II and especially in the 1950s, Keynes’s views began to gain increasing influence over both professional economists and government policy makers. Governments came to believe that they could intervene in their economies to attain specific employment and output goals. They began to use their powers to tax and spend as well as their ability to affect interest rates and the money supply for the explicit purpose of controlling the economy’s level of spending and therefore its ups and downs. This view of government policy became firmly established in the United States with the passage of the Employment Act of 1946. This act established the President’s Council of Economic Advisers, a group of economists who advise the president on economic issues. The act also committed the federal government to intervening in the economy to prevent large declines in output and employment. The view that the government could and should act to stabilize the macroeconomy reached the height of its popularity in the 1960s. During these years, Walter Heller, the chairman of the Council of Economic Advisers under both President John Kennedy and President Lyndon B. Johnson, alluded to fine-tuning as the government’s role in regulating inflation and unemployment. During the 1960s, many economists believed the government could use the tools available to manipulate unemployment and inflation levels fairly precisely. The optimism about the government’s ability to finely manage the economy was short lived. In the 1970s and early 1980s, the U.S. economy had wide fluctuations in employment, output, and inflation. In 1974–1975 and again in 1980
–1982, the United States experienced a 5.3 LEARNING OBJECTIVE Summarize the macroeconomic history of the United States between 1929 and 1970. Great Depression The period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s. fine-tuning The phrase used by Walter Heller to refer to the government’s role in regulating inflation and unemployment. M05_CASE3826_13_GE_C05.indd 125 17/04/19 12:04 PM 126 PART II Concepts and Problems in Macroeconomics Macroeconomics in Literature As you know, the language of economics includes a heavy dose of graphs and equations. But the underlying phenomena that economists study are the stuff of novels as well as graphs and equations. The following two passages, from The Great Gatsby by F. Scott Fitzgerald and The Grapes of Wrath by John Steinbeck, capture in graphic, although not graphical, form the economic growth and spending of the Roaring Twenties and the human side of the unemployment of the Great Depression. The Great Gatsby, written in 1925, is set in the 1920s, whereas The Grapes of Wrath, written in 1939, is set in the early 1930s. If you look at Figure 5.2 for these two periods, you will see the translation of Fitzgerald and Steinbeck into macroeconomics. From The Great Gatsby At least once a fortnight a corps of caterers came down with several hundred feet of canvas and enough colored lights to make a Christmas tree of Gatsby’s enormous garden. On buffet tables, garnished with glistening hors d’oeuvres, spiced baked hams crowded against salads of harlequin designs and pastry pigs and turkeys bewitched to a dark gold. In the main hall a bar with a real brass rail was set up, and stocked with gins and liquors and with cordials so long forgotten that most of his female guests were too young to know one from another. By seven o’clock the orchestra has arrived—no thin five piece affair but a whole pit full of oboes and trombones and saxophones and viols and cornets and piccolos and low and high drums. The last swimmers have come in from the beach now and are dressing upstairs; the cars from New York are parked five deep in the drive, and already the halls and salons and verandas are gaudy with primary
colors and hair shorn in strange new ways and shawls beyond the dreams of Castile. From The Grapes of Wrath The moving, questing people were migrants now. Those families who had lived on a little piece of land, who had lived and died on forty acres, had eaten or starved on the produce of forty acres, had now the whole West to rove in. And they scampered about, looking for work; and the highways were streams of people, and the ditch banks were lines of people. Behind them more were coming. The great highways streamed with moving people. CRITICAL THINKING 1. As we indicate in the introduction to this chapter, macroeconomics focuses on three concerns. Which of these concerns is covered in The Grapes of Wrath excerpt? 2. What economics textbook is featured in The Great Gatsby? Hint: Go to fairmodel.econ.yale.edu/rayfair/pdf/2000c. pdf. Source: From The Grapes of Wrath by John Steinbeck, copyright 1939, renewed © 1967 by John Steinbeck. Used by permission of Viking Penguin, a division of Penguin Group (USA) Inc. and Penguin Group (UK) Ltd. The Great Gatsby by F. Scott Fitzgerald, 1925. M05_CASE3826_13_GE_C05.indd 126 17/04/19 12:04 PM CHAPTER 5 Introduction to Macroeconomics 127 severe recession. Although not as catastrophic as the Great Depression of the 1930s, these two recessions left millions without jobs and resulted in billions of dollars of lost output and income. In 1974–1975 and again in 1979–1981, the United States also saw high rates of inflation. The 1970s was thus a period of stagnation and high inflation, which came to be called stagflation. Stagflation is defined as a situation in which there is high inflation at the same time there are slow or negative output growth and high unemployment. Until the 1970s, high inflation had been observed only in periods when the economy was prospering and unemployment was low. The problem of stagflation was vexing both for macroeconomic theorists and policy makers concerned with the health of the economy. It was clear by 1975 that the macroeconomy was more difficult to control than Heller’s words or textbook theory had led economists to believe. The events of the 1970s and early 1980s had an important influence on macroeconomic theory. Much of the faith in the simple
Keynesian model and the “conventional wisdom” of the 1960s was lost. Although we are now almost fifty years past the 1970s, the discipline of macroeconomics is still in flux and there is no agreed-upon view of how the macroeconomy works. Many important issues have yet to be resolved. This makes macroeconomics hard to teach but exciting to study. The U.S. Economy since 1970 In the following chapters, it will be useful to have a picture of how the U.S. economy has performed recently. Since 1970, the U.S. economy has experienced five recessions and two periods of high inflation. The period since 1970 is illustrated in Figures 5.4, 5.5, and 5.6. These figures are based on quarterly data (that is, data for each quarter of the year). The first quarter consists of January, February, and March; the second quarter consists of April, May, and June; and so on. The Roman numerals I, II, III, and IV denote the four quarters. For example, 1972 III refers to the third quarter of 1972. Figure 5.4 plots aggregate output for 1970 I–2017 IV. The five recessionary periods are 1974 I–1975 I, 1980 II–1982 IV, 1990 III–1991 I, 2001 I–2001 III, and 2008 I–2009 II.2 These stagflation A situation of both high inflation and high unemployment. 5.4 LEARNING OBJECTIVE Describe the U.S. economy since 1970 17,000 16,000 15,000 14,000 13,000 12,000 11,000 10,000 9,000 8,000 7,000 6,000 5,000 4,000 1970 I — Recessionary period (1974 I– 1975 I) — Recessionary period (1980 II–1982 IV) Recessionary period — (1990 III–1991 I) Recessionary period — (2001 I–2001 III) — Recessionary period (2008 I–2009 II) 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I Quarters 2010 I 2015 I 2017 IV MyLab Economics Real-time data ▴ FIGURE 5.4 Aggregate Output (Real GDP), 1970 I–2017 IV Aggregate output in the United States since 1970 has risen overall, but there have been five recessionary periods: 1974 I–1975 I, 1980 II–1982 IV, 1990 III–1991 I, 2001 I–2001 III, and 2008 I
–2009 II. 2 Regarding the 1980 II–1982 IV period, output rose in 1980 IV and 1981 I before falling again in 1981 II. Given this fact, one possibility would be to treat the 1980 II–1982 IV period as if it included two separate recessionary periods: 1980 II–1980 III and 1981 I–1982 IV. Because the expansion was so short-lived, however, we have chosen not to separate the period into two parts. These periods are close to but are not exactly the recessionary periods defined by the National Bureau of Economic Research (NBER). The NBER is considered the “official” decider of recessionary periods. One problem with the NBER definitions is that they are never revised, but the macro data are, sometimes by large amounts. This means that the NBER periods are not always those that would be chosen using the latest revised data. In November 2008 the NBER declared that a recession began in December 2007. In September 2010 it declared that the recession ended in June 2009. M05_CASE3826_13_GE_C05.indd 127 17/04/19 12:04 PM 128 PART II Concepts and Problems in Macroeconomics ) 12 10 8 6 4 2 0 1970 I —Recessionary period (1974 I– 1975 I) —Recessionary period (1980 II–1982 IV) Recessionary period— (2001 I–2001 III) — Recessionary period (2008 I–2009 II) Recessionary period— (1990 III–1991 I) 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I Quarters 2010 I 2015 I 2017 IV MyLab Economics Real-time data ▴ FIGURE 5.5 Unemployment Rate, 1970 I–2017 IV The U.S. unemployment rate since 1970 shows wide variations. The five recessionary reference periods show increases in the unemployment rate. five periods are shaded in the figure. Figure 5.5 plots the unemployment rate for the same overall period with the same shading for the recessionary periods. Note that unemployment rose in all five recessions. In the 1974–1975 recession, the unemployment rate reached a maximum of 8.8 percent in the second quarter of 1975. During the 1980–1982 recession, it reached a maximum of 10.7 percent in the fourth quarter of 1982. The unemployment rate continued to rise after the 1990–1991 recession and reached a peak of 7.6 percent in the third quarter of 1992. In the 2008–2009 recession it reached a peak
of 9.9 percent in the fourth quarter of 2009. By 2015 the unemployment rate was 5.5 percent. Figure 5.6 plots the inflation rate for 1970 I–2017 IV. The two high inflation periods are 1973 IV–1975 IV and 1979 I–1981 IV, which are shaded. In the first high inflation period, the inflation rate peaked at 11.1 percent in the first quarter of 1975. In the second high inflation period, inflation peaked at 10.2 percent in the first quarter of 1981. Since 1983, the inflation rate has been quite low by the standards of the 1970s. Since 1992, it has been between about 1 and 3 percent. In the following chapters, we will explain the behavior of and the connections among variables such as output, unemployment, and inflation. When you understand the forces at work in creating the movements shown in Figures 5.4, 5.5, and 5.6, you will have come a long way in understanding how the macroeconomy works High inﬂation period (1973 IV –1975 IV) –– High inﬂation period (1979 I– 1981 IV) –– 12 10 8 6 4 2 0 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I Quarters 2010 I 2015 I 2017 IV MyLab Economics Real-time data Inflation Rate (Percentage Change in the GDP Deflator, ▴ FIGURE 5.6 Four-Quarter Average), 1970 I–2017 IV Since 1970, inflation has been high in two periods: 1973 IV–1975 IV and 1979 I–1981 IV. Inflation between 1983 and 1992 was moderate. Since 1992, it has been fairly low. M05_CASE3826_13_GE_C05.indd 128 17/04/19 12:04 PM CHAPTER 5 Introduction to Macroeconomics 129 S U M M A R Y 1. Microeconomics examines the functioning of individual industries and the behavior of individual decision-making units. Macroeconomics is concerned with the sum, or aggregate, of these individual decisions—the consumption of all households in the economy, the amount of labor supplied and demanded by all individuals and firms, and the total amount of all goods and services produced. markets in which they interact: the goods-and-services market, labor market, and money (financial) market. 5. Among the tools that the government has available for influencing the macroeconomy are fiscal policy (decisions on taxes and government spending)
and monetary policy (control of short term interest rates). 5.1 MACROECONOMIC CONCERNS p. 119 2. The three topics of primary concern to macroeconomists are the growth rate of aggregate output, the level of unemployment, and increases in the overall price level, or inflation. 5.2 THE COMPONENTS OF THE MACROECONOMY p. 122 3. The circular flow diagram shows the flow of income received and payments made by the four groups in the economy— households, firms, the government, and the rest of the world. Everybody’s expenditure is someone else’s receipt— every transaction must have two sides. 4. Another way of looking at how households, firms, the government, and the rest of the world relate is to consider the 5.3 A BRIEF HISTORY OF MACROECONOMICS p. 125 6. Macroeconomics was born out of the effort to explain the Great Depression of the 1930s. Since that time, the discipline has evolved, concerning itself with new issues as the problems facing the economy have changed. Through the late 1960s, it was believed that the government could fine-tune the economy to keep it running on an even keel at all times. The poor economic performance of the 1970s, however, showed that fine-tuning does not always work. 5.4 THE U.S. ECONOMY SINCE 1970 p. 127 7. Since 1970, the U.S. economy has seen five recessions and two periods of high inflation aggregate behavior, p. 119 aggregate output, p. 119 business cycle, p. 119 circular flow, p. 122 contraction, recession, or slump, p. 120 corporate bonds, p. 124 deflation, p. 121 depression, p. 120 dividends, p. 124 expansion or boom, p. 120 fine-tuning, p. 125 fiscal policy, p. 124 Great Depression, p. 125 hyperinflation, p. 121 inflation, p. 121 macroeconomics, p. 118 microeconomics, p. 118 monetary policy, p. 124 shares of stock, p. 124 stagflation, p. 127 sticky prices, p. 119 transfer payments, p. 122 Treasury bonds, notes, or bills, p. 124 unemployment rate, p. 121 P R O B L E M S All problems are available on MyLab Economics. 5.1 MACROECONOMIC CONCERNS LEARNING OBJECT
IVE: Describe the three primary concerns of macroeconomics. 1.1 Define inflation. Assume that you live in a simple econ- omy in which only three goods are produced and traded: cashews, pecans, and almonds. Suppose that on January 1, 2018, cashews sold for $12.50 per pound, pecans were $4.00 per pound, and almonds were $5.50 per pound. At the end of the year, you discover that the cashew crop was lower than expected and that cashew prices had increased to $17.00 per pound, but pecan prices stayed at $4.00 and almond prices had actually fallen to $3.00. Can you say what happened to the overall “price level”? How might you construct a measure of the “change in the price level”? What additional information might you need to construct your measure? 1.2 Define unemployment. Should everyone who does not hold a job be considered “unemployed”? To help with your answer, draw a supply and demand diagram depicting the labor market. What is measured along the demand curve? What factors determine the quantity of labor demanded during a given period? What is measured along the labor supply curve? What factors determine the quantity of MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M05_CASE3826_13_GE_C05.indd 129 17/04/19 12:04 PM 130 PART II Concepts and Problems in Macroeconomics labor supplied by households during a given period? What is the opportunity cost of holding a job? 1.3 According to Eurostat, a Directorate-General of the European Commission, the unemployment rate in Spain stood at 9.1 percent at the beginning of 2008, when the Great Recession began and hit its peak in July 2013 at 26.3 percent. In 2012, the country’s GDP grew at –2.9 percent. Since then, Spain has experienced a steady decline in unemployment, receding to 15.2 percent as of June 2018. How is it possible that output can decrease while at the same time unemployment decreases? 1.4 Describe the state of the economy in your country, both in dynamic terms (comparing this year with the last few years) and comparative terms (with other countries
of a similar income category). Is economic growth strong or weak? Is unemployment high or low? Is inflation excessive or not? How have economic growth, unemployment, and inflation evolved over the past few years? 1.5 Explain briefly how macroeconomics is different from microeconomics. How can macroeconomists use microeconomic theory to guide them in their work, and why might they want to do so? 1.6 According to a 2001 study by Berndt and Rappaport, the average price of desktop computers in the United States declined such that the 1999 price was only 0.069 percent of the 1976 price—a 1,445-fold decrease over 23 years. Does this imply that U.S. consumers’ purchasing power increased 1,445 times during that period? What do increases or decreases in individual goods’ price levels tell us about inflation? About consumers’ purchasing power? 5.2 THE COMPONENTS OF THE MACROECONOMY LEARNING OBJECTIVE: Discuss the interaction between the four components of the macroeconomy. 2.1 Since 2009–2010, several member states of the European Union (EU) have adopted contractionary fiscal policy measures consisting of cuts in government spending and increases in taxation. These policies, often dubbed “austerity” policies by their opponents, have led the latter to question their opportunity in a context of slow economic growth and high unemployment. Explain their logic. 2.2 In which of the three market arenas is each of the follow- ing traded? a. A government bond b. A haircut from Hershesons hair salon, London c. The skills and expertise of an economist like Paul R. Krugman d. A pair of second-hand Adidas sneakers from a local market e. The average goals scored by Cristiano Ronaldo f. An insurance contract for your car 5.3 A BRIEF HISTORY OF MACROECONOMICS LEARNING OBJECTIVE: Summarize the macroeconomic history of the United States between 1929 and 1970. 3.1 Many of the expansionary periods during the twentieth cen- tury occurred during wars. Why do you think this is true? 3.2 John Maynard Keynes was the first to show that govern- ment policy could be used to change aggregate output and prevent recession by stabilizing the economy. Describe the economy of the world at the time Keynes was writing. Describe the economy of the United States today. What measures were being proposed by the major presidential candidates
in 2016 to stimulate growth in the economy? Did any of these proposed policies follow the policies proposed by John Maynard Keynes? If so, which policies and from which candidates? 3.3 Assume that the demand for flight attendants increases significantly as a result of an increase in demand for air travel. Explain what will happen to unemployment using both classical and Keynesian reasoning. 3.4 Explain why the length and severity of the Great Depression necessitated a fundamental rethinking of the operations of the macroeconomy. 5.4 THE U.S. ECONOMY SINCE 1970 LEARNING OBJECTIVE: Describe the U.S. Economy since 1970. 4.1 [Related to the Economics in Practice on p. 126 ] The Economics in Practice describes prosperity and recession as they are depicted in literature. Looking at data on GDP growth released by the Organization for Economic Cooperation and Development (OECD) in its Interim Economic Outlook (available at http://www.oecd.org), how would you compare the economic performance of “emerging markets,” such as Brazil, China, and Russia, with respect to advanced industrial economies like Germany, the United Kingdom, and the United States over the past year or two? Are these economies expanding or shrinking QUESTION 1 Economic policies are often designed to “soften” the business cycle. These policies are meant to raise toughs and reduce the peaks. Why might economic policy be designed to reduce peaks in aggregate output? QUESTION 2 Figure 5.5 shows that unemployment rate often continues to rise even after a recession has ended. Why might this occur? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with. M05_CASE3826_13_GE_C05.indd 130 17/04/19 12:04 PM Measuring National Output and National Income 6 CHAPTER OUTLINE AND LEARNING OBJECTIV ES 6.1 Gross Domestic Product p. 132 Describe GDP fundamentals and differentiate between GDP and GNP. 6.2 Calculating GDP p. 134 Explain two methods for calculating GDP. 6.3 Nominal versus Real GDP p. 140 Discuss the difference between real GDP and nominal GDP. 6.4 Limitations of the GDP Concept p. 144 Discuss the limitations of using GDP to measure well-being. Looking Ahead p. 147 131 We saw in the last chapter
that macroeconomics is concerned with aggregate output, unemployment, and inflation. In this chapter, we discuss the measurement of aggregate output and inflation. In the next chapter, we discuss the measurement of unemployment. Accurate measures of these variables are critical for understanding the economy. Without good measures, economists would have a hard time analyzing how the economy works and policy makers would have little to guide them on which policies are best for the economy. Much of the macroeconomic data we use come from the national income and product accounts, which are compiled by the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce. It is hard to overestimate the importance of these accounts. They are, in fact, one of the great inventions of the twentieth century. (See the Economics in Practice, p. 141.) They not only convey data about the performance of the economy but also provide a conceptual framework that macroeconomists use to think about how the pieces of the economy fit together. When economists think about the macroeconomy, the categories and vocabulary they use come from the national income and product accounts. The national income and product accounts can be compared with the mechanical or wiring diagrams for an automobile engine. The diagrams do not explain how an engine works, but they identify the key parts of an engine and show how they are connected. Trying to understand the macroeconomy without understanding national income accounting is like trying to fix an engine without a mechanical diagram and with no names for the engine parts. M06_CASE3826_13_GE_C06.indd 131 17/04/19 12:16 AM 132 PART II Concepts and Problems in Macroeconomics national income and product accounts Data collected and published by the government describing the various components of national income and output in the economy. 6.1 LEARNING OBJECTIVE Describe GDP fundamentals and differentiate between GDP and GNP. gross domestic product (GDP) The total market value of all final goods and services produced within a given period by factors of production located within a country. final goods and services Goods and services produced for final use. intermediate goods Goods that are produced by one firm for use in further processing or for resale by another firm. value added The difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage. There are literally thousands of variables in the national income and product accounts. In this chapter, we discuss only the most important. This chapter is meant to convey the way
the national income and product accounts represent or organize the economy and the sizes of the various pieces of the economy. Gross Domestic Product The key concept in the national income and product accounts is gross domestic product (GDP). GDP is the total market value of a country’s output. It is the market value of all final goods and services produced within a given period of time by factors of production located within a country. U.S. GDP for 2017—the value of all output produced by factors of production in the United States in 2017—was $19,390.6 billion. GDP is a critical concept. Just as an individual firm needs to evaluate the success or failure of its operations each year, so the economy as a whole needs to assess itself. GDP, as a measure of the total production of an economy, provides us with a country’s economic report card. Because GDP is so important, we need to take time to explain exactly what its definition means. Final Goods and Services MyLab Economics Concept Check First, note that the definition refers to final goods and services. Many goods produced in the economy are not classified as final goods, but instead as intermediate goods. Intermediate goods are produced by one firm for use in further processing or for resale by another firm. For example, tires sold to automobile manufacturers are intermediate goods. The chips that go in Apple’s iPhone are also intermediate goods. The value of intermediate goods is not counted in GDP. Why are intermediate goods not counted in GDP? Suppose that in producing a car, General Motors (GM) pays $200 to Goodyear for tires. GM uses these tires (among other components) to assemble a car, which it sells for $24,000. The value of the car (including its tires) is $24,000, not +24,000 + +200. The final price of the car already reflects the value of all its components. To count in GDP both the value of the tires sold to the automobile manufacturers and the value of the automobiles sold to the consumers would result in double counting. It would also lead us to conclude that a decision by GM to produce its own tires rather than buy them from Goodyear leads to a reduction in the value of goods produced by the economy. Double counting can also be avoided by counting only the value added to a product by each firm in its production process. The value added during some stage of production is the difference between the value of goods as they leave that stage of production and the cost of the goods
as they entered that stage. Value added is illustrated in Table 6.1. The four stages of the production of a gallon of gasoline are: (1) oil drilling, (2) refining, (3) shipping, and (4) retail sale. In the first stage, value added is the value of the crude oil. In the second stage, the refiner purchases the oil from the driller, refines it into gasoline, and sells it to the shipper. The refiner pays the driller $3.00 per gallon and charges the shipper $3.30. The value added by the refiner is thus $0.30 per TABLE 6.1 Value Added in the Production of a Gallon of Gasoline (Hypothetical Numbers) Stage of Production Value of Sales Value Added (1) Oil drilling (2) Refining (3) Shipping (4) Retail sale Total value added $3.00 3.30 3.60 4.00 $3.00 0.30 0.30 0.40 $4.00 It is sometimes useful to have a measure of the output produced by factors of production owned by a country’s citizens regardless of where the output is produced. This measure is called gross national product (GNP). For most countries, including the United States, the difference between GDP and GNP is small. In 2017, GNP for the United States was $19,607.4 billion, which is close to the $19,390.6 billion value for U.S. GDP. The distinction between GDP and GNP can be tricky. Consider the Honda plant in Marysville, Ohio. The plant is owned by the Honda Corporation, a Japanese firm, but most of the workers gross national product (GNP) The total market value of all final goods and ser- vices produced within a given period by factors of production owned by a country’s citizens, regardless of where the output is produced. M06_CASE3826_13_GE_C06.indd 132 17/04/19 12:16 AM gallon. The shipper then sells the gasoline to retailers for $3.60. The value added in the third stage of production is $0.30. Finally, the retailer sells the gasoline to consumers for $4.00. The value added at the fourth stage is $0.40, and the total value added in the production process is $4.00, the same as the value of sales
at the retail level. Adding the total values of sales at each stage of production (+3.00 + +3.30 + +3.60 + +4.00 = +13.90) would significantly overestimate the value of the gallon of gasoline. In calculating GDP, we can sum up the value added at each stage of production or we can take the value of final sales. We do not use the value of total sales in an economy to mea- sure how much output has been produced. Exclusion of Used Goods and Paper Transactions MyLab Economics Concept Check GDP is concerned only with new, or current, production. Old output is not counted in current GDP because it was already counted when it was produced. It would be double counting to count sales of used goods in current GDP. If someone sells a used car to you, the transaction is not counted in GDP because no new production has taken place. Similarly, a house is counted in GDP only at the time it is built, not each time it is resold. In short: GDP does not count transactions in which money or goods changes hands and in which no new goods and services are produced. Sales of stocks and bonds are not counted in GDP. These exchanges are transfers of ownership of assets, either electronically or through paper exchanges, and do not correspond to current pro- duction. What if you sell the stock or bond for more than you originally paid for it? Profits from the stock or bond market have nothing to do with current production, so they are not counted in GDP. However, if you pay a fee to a broker for selling a stock of yours to someone else, this fee is counted in GDP because the broker is performing a service for you. This service is part of current production. Be careful to distinguish between exchanges of stocks and bonds for money (or for other stocks and bonds), which do not involve current production, and fees for performing such exchanges, which do. Exclusion of Output Produced Abroad by Domestically Owned Factors of Production MyLab Economics Concept Check GDP is the value of output produced by factors of production located within a country. The three basic factors of production are land, labor, and capital. The output produced by U.S. citizens abroad—for example, U.S. citizens working for a foreign company—is not counted in U.S. GDP because the output is not produced within the United States. Likewise, profits earned abroad by U.S. companies are not counted in U.S.
GDP. However, the output produced by for- eigners working in the United States is counted in U.S. GDP because the output is produced within the United States. Also, profits earned in the United States by foreign-owned companies are counted in U.S. GDP. CHAPTER 6 Measuring National Output and National Income 133 gallon. The shipper then sells the gasoline to retailers for $3.60. The value added in the third stage of production is $0.30. Finally, the retailer sells the gasoline to consumers for $4.00. The value added at the fourth stage is $0.40, and the total value added in the production process is $4.00, the same as the value of sales at the retail level. Adding the total values of sales at each stage of production (+3.00 + +3.30 + +3.60 + +4.00 = +13.90) would significantly overestimate the value of the gallon of gasoline. In calculating GDP, we can sum up the value added at each stage of production or we can take the value of final sales. We do not use the value of total sales in an economy to measure how much output has been produced. Exclusion of Used Goods and Paper Transactions MyLab Economics Concept Check GDP is concerned only with new, or current, production. Old output is not counted in current GDP because it was already counted when it was produced. It would be double counting to count sales of used goods in current GDP. If someone sells a used car to you, the transaction is not counted in GDP because no new production has taken place. Similarly, a house is counted in GDP only at the time it is built, not each time it is resold. In short: GDP does not count transactions in which money or goods changes hands and in which no new goods and services are produced. Sales of stocks and bonds are not counted in GDP. These exchanges are transfers of ownership of assets, either electronically or through paper exchanges, and do not correspond to current production. What if you sell the stock or bond for more than you originally paid for it? Profits from the stock or bond market have nothing to do with current production, so they are not counted in GDP. However, if you pay a fee to a broker for selling a stock of yours to someone else, this fee is counted in GDP because the broker is performing a service for you. This service is part of current production. Be careful to distinguish between exchanges of stocks
and bonds for money (or for other stocks and bonds), which do not involve current production, and fees for performing such exchanges, which do. Exclusion of Output Produced Abroad by Domestically Owned Factors of Production MyLab Economics Concept Check GDP is the value of output produced by factors of production located within a country. The three basic factors of production are land, labor, and capital. The output produced by U.S. citizens abroad—for example, U.S. citizens working for a foreign company—is not counted in U.S. GDP because the output is not produced within the United States. Likewise, profits earned abroad by U.S. companies are not counted in U.S. GDP. However, the output produced by foreigners working in the United States is counted in U.S. GDP because the output is produced within the United States. Also, profits earned in the United States by foreign-owned companies are counted in U.S. GDP. It is sometimes useful to have a measure of the output produced by factors of production owned by a country’s citizens regardless of where the output is produced. This measure is called gross national product (GNP). For most countries, including the United States, the difference between GDP and GNP is small. In 2017, GNP for the United States was $19,607.4 billion, which is close to the $19,390.6 billion value for U.S. GDP. The distinction between GDP and GNP can be tricky. Consider the Honda plant in Marysville, Ohio. The plant is owned by the Honda Corporation, a Japanese firm, but most of the workers gross national product (GNP) The total market value of all final goods and services produced within a given period by factors of production owned by a country’s citizens, regardless of where the output is produced. M06_CASE3826_13_GE_C06.indd 133 17/04/19 12:16 AM value added The difference between the value of goods as they leave a stage of produc- tion and the cost of the goods as they entered that stage. 134 PART II Concepts and Problems in Macroeconomics employed at the plant are U.S. workers. Although all the output of the plant is included in U.S. GDP, only part of it is included in U.S. GNP. The wages paid to U.S. workers are part of U.S. GNP, whereas
the profits from the plant are not. The profits from the plant are counted in Japanese GNP because this is output produced by Japanese-owned factors of production (Japanese capital in this case). The profits, however, are not counted in Japanese GDP because they were not earned in Japan. 6.2 LEARNING OBJECTIVE Explain two methods for calculating GDP. expenditure approach A method of computing GDP that measures the total amount spent on all final goods and services during a given period. income approach A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods and services. Calculating GDP GDP can be computed two ways. One way is to add up the total amount spent on all final goods and services during a given period. This is the expenditure approach to calculating GDP. The other way is to add up the income—wages, rents, interest, and profits—received by all factors of production in producing final goods and services. This is the income approach to calculating GDP. These two methods lead to the same value for GDP for the reason we discussed in the previous chapter: Every payment (expenditure) by a buyer is at the same time a receipt (income) for the seller. We can measure either income received or expenditures made, and we will end up with the same total output. Suppose the economy is made up of just one firm and the firm’s total output this year sells for $1 million. Because the total amount spent on output this year is $1 million, this year’s GDP is $1 million. (Remember: The expenditure approach calculates GDP on the basis of the total amount spent on final goods and services in the economy.) However, every one of the million dollars of GDP either is paid to someone or remains with the owners of the firm as profit. Using the income approach, we add up the wages paid to employees of the firm, the interest paid to those who lent money to the firm, and the rents paid to those who leased land, buildings, or equipment to the firm. What is left over is profit, which is, of course, income to the owners of the firm. If we add up the incomes of all the factors of production, including profits to the owners, we get a GDP of $1 million. The Expenditure Approach MyLab Economics Concept Check Recall from the previous chapter the four main groups in the economy: households, firms, the government, and the rest of the
world. There are also four main categories of expenditure: ■■ Personal consumption expenditures (C): household spending on consumer goods ■■ Gross private domestic investment (I a): spending by firms and households on new capital, that is, plant, equipment, inventory, and new residential structures1. ■■ Government consumption and gross investment (G) ■■ Net exports (EX - IM): net spending by the rest of the world, or exports (EX) minus imports (IM) The expenditure approach calculates GDP by adding together these four components of spending. It is shown here in equation form: GDP = C + I a + G + (EX - IM) U.S. GDP was $19,390.6 billion in 2017. The four components of the expenditure approach are shown in Table 6.2, along with their various categories. personal consumption expenditures (C) Expenditures by consumers on goods and services. durable goods Goods that last a relatively long time, such as cars and household appliances. nondurable goods Goods that are used up fairly quickly, such as food and clothing. services The things we buy that do not involve the production of physical things, such as legal and medical services and education. Personal Consumption Expenditures (C) The largest part of GDP consists of personal consumption expenditures (C). Table 6.2 shows that in 2017, the amount of personal consumption expenditures accounted for 69.1 percent of GDP. These are expenditures by consumers on goods and services. There are three main categories of consumer expenditures: durable goods, nondurable goods, and services. Durable goods, such as automobiles, furniture, and household appliances, last a relatively long time. Nondurable goods, such as food, clothing, and gasoline, are used up fairly quickly. Payments for services—those things we buy that do not involve the production 1When we begin the macro theory in Chapter 8, we need to distinguish between actual investment and planned investment. We will use I to denote planned investment, and so in this chapter we will use I a not to confuse the two. We will see that sometimes planned investment is not equal to actual investment. to denote actual investment so as M06_CASE3826_13_GE_C06.indd 134 17/04/19 12:16 AM Are Christie’s Brokerage Services Counted in GDP? CHAPTER 6 Measuring National Output and National Income 135 Christie’s is the world’s oldest and largest auction house, dealing in fine art, antiques
, jewelry, and real estate with 85 offices in over 43 countries. In 2017, seven out of the top-notch ten art works were sold at this British auction house. Each item is simultaneously bidden for via a live platform, online, and through phone orders. In 2017, the auction art sales at Christie’s broke its own worldwide sales record of €5.8 billion. The most significant art piece sold that year was Leonardo da Vinci’s masterpiece, Salvator Mundi or Savior of the World, which was sold by Russian collector Dmitry Rybolovlev to Louvre Abu Dhabi for over $450 million at Christie’s New York auction house. This is the highest price ever paid for an art piece at any auction. So which country’s GDP should da Vinci’s sixteenth century masterpiece count as a part of—France, Abu Dhabi, Russia, the United States, or the United Kingdom? Since the painting was commissioned in the early sixteenth century by the French monarch, Louis XII, it was counted as part of France’s GDP in the year when it was painted, i.e., 1,500. The sale does not affect either Abu Dhabi or Russia’s GDP. However, since Christie’s services were rendered on U.S. soil by the British auction house via its New York branch, it would have been recorded as a service brokerage fee in the United States’ GDP in 2017. As we shall study later in the chapter, once the brokerage income fee is remitted to the United Kingdom, it is recorded under its national income or gross national product (GNP). So although masterpieces like these date way back to the early sixteenth century and its valuation does not contribute to current GDP, the cost of getting together interested buyers and getting a lucrative price for it does indeed get counted. CRITICAL THINKING 1. Would a contemporary painting completed in 2017 and sold by Christie’s in the same year be recorded in GDP of 2017? What about a painting painted in 2015? of physical items—include expenditures for doctors, lawyers, and educational institutions. As Table 6.2 shows, in 2017, durable goods expenditures accounted for 7.6 percent of GDP, nondurables for 14.6 percent, and services for 46.9 percent. Almost half of GDP is now service consumption. Gross Private Domestic Investment (I a) Investment, as we use the term in economics, refers to the purchase of new
capital—housing, plants, equipment, and inventory. The economic use of the term is in contrast to its everyday use, where investment often refers to purchases of stocks, bonds, or mutual funds. Total investment in capital by the private sector is called gross private domestic investment (I a). Expenditures by firms for machines, tools, plants, and so on make up nonresidential investment.1 Because these are goods that firms buy for their own final use, they are part of “final sales” and counted in GDP. Expenditures for new houses and apartment buildings constitute residential investment. The third component of gross private domestic investment, the change in business inventories, is the amount by which firms’ inventories change during a period. Business inventories can be looked at as the goods that firms produce now but intend to sell later. In 2017, gross private domestic investment accounted for 16.6 percent of GDP. Of that, 12.6 percent was nonresidential investment, 3.9 percent was residential investment, and 0.1 percent was change in business inventories. gross private domestic investment (Ia). Total investment in capital—that is, the purchase of new housing, plants, equipment, and inventory by the private (or nongovernment) sector. nonresidential investment Expenditures by firms for machines, tools, plants, and so on. residential investment Expenditures by households and firms on new houses and apartment buildings. Change in Business Inventories Why is the change in business inventories considered a component of investment—the purchase of new capital? To run a business most firms hold inventories, in part because they cannot predict exactly how much will be sold each day and want to avoid losing sales by running out of a product. Inventories—goods produced for later sale—are counted as capital because they produce value in the future. An increase in inventories is an increase in capital. change in business inventories The amount by which firms’ inventories change during a period. Inventories are the goods that firms produce now but intend to sell later. M06_CASE3826_13_GE_C06.indd 135 17/04/19 12:16 AM 136 PART II Concepts and Problems in Macroeconomics TABLE 6.2 Components of U.S. GDP, 2017: The Expenditure Approach Billions of Dollars ($) Percentage of GDP (%) Personal consumption expenditures (C) Durable goods Nondurable goods Services Gross private domestic investment (I a)
Nonresidential Residential Change in business inventories Government consumption and gross investment (G) Federal State and local Net exports (EX - IM) Exports (EX) Imports (IM) 13,395.5 3,212.8 3,353.8 −571.6 1,473.8 2,821.5 9,100.2 2,449.6 747.6 15.7 1,260.7 2,093.2 2,344.0 2,915.6 69.1 16.6 17.3 −2.9 Gross domestic product 19390.6 100.0 7.6 14.6 46.9 12.6 3.9 0.1 6.5 10.8 12.1 15.0 Note: Numbers may not add exactly because of rounding. Source: U.S. Bureau of Economic Analysis, March 28, 2018. MyLab Economics Real-time data Regarding GDP, remember that it is not the market value of total final sales during the period, but rather the market value of total final production. The relationship between total production and total sales is as follows: GDP = Final sales + Change in business inventories Total production (GDP) equals final sales of domestic goods plus the change in business inventories. In 2017, production in the United States was larger than sales by $15.7 billion. The stock of inventories at the end of 2017 was $15.7 billion larger than it was at the end of 2016—the change in business inventories was $15.7 billion. Gross Investment versus Net Investment During the process of production, capital (especially machinery and equipment) produced in previous periods gradually wears out. GDP includes newly produced capital goods but does not take account of capital goods “consumed” in the production process. As a result, GDP overstates the real production of an economy because it does not account for the part of that production that serves just to replace worn out capital. The amount by which an asset’s value falls each period is called its depreciation.2 A personal computer purchased by a business today may be expected to have a useful life of 4 years before becoming worn out or obsolete. Over that period, the computer steadily depreciates. What is the relationship between gross investment (I a) and depreciation? Gross investment is the total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period. It takes no account of the fact
that some capital wears out and must be replaced. Net investment is equal to gross investment minus depreciation. Net investment is a measure of how much the stock of capital changes during a period. Positive net investment means that the amount of new capital produced exceeds the amount that wears out, and negative net investment means that the amount of new capital produced is less than the amount that wears out. Therefore, if net investment is positive, the capital stock has increased, and if net investment depreciation The amount by which an asset’s value falls in a given period. gross investment The total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period. net investment Gross investment minus depreciation. 1The distinction between what is considered investment and what is considered consumption is sometimes fairly arbitrary. A firm’s purchase of a car or a truck is counted as investment, but a household’s purchase of a car or a truck is counted as consumption of durable goods. In general, expenditures by firms for items that last longer than a year are counted as investment expenditures. Expenditures for items that last less than a year are seen as purchases of intermediate goods. 2This is the formal definition of economic depreciation. Because depreciation is difficult to measure precisely, accounting rules allow firms to use shortcut methods to approximate the amount of depreciation that they incur each period. To complicate matters even more, the U.S. tax laws allow firms to deduct depreciation for tax purposes under a different set of rules. M06_CASE3826_13_GE_C06.indd 136 17/04/19 12:16 AM is negative, the capital stock has decreased. Put another way, the capital stock at the end of a pe- riod is equal to the capital stock that existed at the beginning of the period plus net investment: capitalend of period = capitalbeginning of period + net investment Government Consumption and Gross Investment (G) Government consumption government consumption and and gross investment (G) include expenditures by federal, state, and local governments for final gross investment (G) goods (bombs, pencils, school buildings) and services (military salaries, congressional salaries, school teachers’ salaries). Some of these expenditures are counted as government consump- tion, and some are counted as government gross investment. Government transfer payments (Social Security benefits, veterans’ disability stipends, and so on) are not included in G because these transfers are not purchases of anything currently produced. The payments are not
made in exchange for any goods or services. Because interest payments on the government debt are also counted as transfers, they are excluded from GDP on the grounds that they are not payments for current goods or services. As Table 6.2 shows, government consumption and gross investment accounted for $3,353.8 billion, or 17.3 percent of U.S. GDP, in 2017. Federal government consumption and gross invest- ment accounted for 6.5 percent of GDP, and state and local government consumption and gross investment accounted for 10.8 percent. Expenditures by federal, state, and local governments for final goods and services. net exports (EX - IM) The difference between exports (sales to foreigners of U.S. produced goods and services) and imports (U.S. purchases of goods and services from abroad). The figure can be Net Exports (EX − IM) The value of net exports (EX - IM) is the difference between ex- ports (sales to foreigners of U.S.-produced goods and services) and imports (U.S. purchases of goods and services from abroad). This figure can be positive or negative. In 2017, the United positive or negative Estimating Depreciation in the National Income and Product Accounts CHAPTER 6 Measuring National Output and National Income 137 As we suggest in the text, in order to estimate GDP the government needs to know how much of the economy’s new investment is really incremental and how much just replaces worn out stock. But how does the government figure this out? For some products, the calculation is relatively simple. Depreciation is mostly physical, and we can get some data on when those goods fall apart and are no longer useful. But many other goods, particularly in the high tech area, depreciate not so much from physical wear and tear but because they become obsolete. How is the depreciation of these goods determined? A paper by four Federal Reserve Board economists takes us through the calculation of depreciation rates for personal computers.1 Using data on prices and model characteristics for more than 10,000 transactions involving used personal computers, these researchers were able to determine the depreciation rate of personal computers by type. Their results indicated that computers lose roughly half their value with each additional year of use. Most of this depreciation comes from the inability of older models to match the functionality of the newer models. So depreciation comes not so much because the machines cannot do what they always did, but because expectations for what a computer needs to be able to do change over time as new
machines enter the workplace. Interestingly, the estimates of these economists made their way into the depreciation schedules used by the government in constructing the NIPA accounts, showing us the practical importance of macroeconomics. CRITICAL THINKING 1. If a computer is initially worth $1,000 and loses half of its value per year, what is its value after three years of depreciation? How much depreciation takes place in the third year? 1Mark Doms, Wendy Dunn, Stephen Oliner, Daniel SIchel, “How Fast do Personal Computers Depreciate?” in James Poterba, ed, “Tax Policy and the Economy.” MIT Press, 2007. is negative, the capital stock has decreased. Put another way, the capital stock at the end of a period is equal to the capital stock that existed at the beginning of the period plus net investment: capitalend of period = capitalbeginning of period + net investment Government Consumption and Gross Investment (G) Government consumption and gross investment (G) include expenditures by federal, state, and local governments for final goods (bombs, pencils, school buildings) and services (military salaries, congressional salaries, school teachers’ salaries). Some of these expenditures are counted as government consumption, and some are counted as government gross investment. Government transfer payments (Social Security benefits, veterans’ disability stipends, and so on) are not included in G because these transfers are not purchases of anything currently produced. The payments are not made in exchange for any goods or services. Because interest payments on the government debt are also counted as transfers, they are excluded from GDP on the grounds that they are not payments for current goods or services. As Table 6.2 shows, government consumption and gross investment accounted for $3,353.8 billion, or 17.3 percent of U.S. GDP, in 2017. Federal government consumption and gross investment accounted for 6.5 percent of GDP, and state and local government consumption and gross investment accounted for 10.8 percent. Net Exports (EX − IM) The value of net exports (EX - IM) is the difference between exports (sales to foreigners of U.S.-produced goods and services) and imports (U.S. purchases of goods and services from abroad). This figure can be positive or negative. In 2017, the United government consumption and gross investment (G) Expenditures by federal, state, and local governments for final goods and services. net exports (EX - IM
) The difference between exports (sales to foreigners of U.S. produced goods and services) and imports (U.S. purchases of goods and services from abroad). The figure can be positive or negative. M06_CASE3826_13_GE_C06.indd 137 17/04/19 12:16 AM gross investment The total value of all newly produced capital goods (plant, equip- ment, housing, and inventory) produced in a given period. net investment Gross investment minus depreciation. 138 PART II Concepts and Problems in Macroeconomics States exported less than it imported, so the level of net exports was negative (–$571.6 billion). Before 1976, the United States was generally a net exporter—exports exceeded imports, so the net export figure was positive. national income The total income earned by the factors of production owned by a country’s citizens. compensation of employees wages, salaries, and various supplements—employer contributions to social insurance and pension funds, for example— paid to households by firms and by the government. Includes proprietors’ income The income of unincorporated businesses. rental income The income received by property owners in the form of rent. corporate profits The income of corporations. net interest The interest paid by business. indirect taxes minus subsidies Taxes such as sales taxes, customs duties, and license fees less subsidies that the government pays for which it receives no goods or services in return. Is net revenue received by the government. net business transfer payments Net transfer payments by businesses to others. surplus of government enterprises ernment enterprises. Income of gov- The reason for including net exports in the definition of GDP is simple. Consumption, inC, I a, and G, respectively vestment, and government spending include expenditures on goods produced at home and abroad. Therefore, C + I a + G overstates domestic production because it contains expenditures on foreign-produced goods—that is, imports (IM), which have to be subtracted from GDP to obtain the correct figure. At the same time, C + I a + G understates domestic production because some of what a nation produces is sold abroad and therefore is not included in C, I a, or G:exports (EX) have to be added in. If a U.S. firm produces smartphones and sells them in Germany, the smartphones are part of U.S. production and should be counted as part of U.S. GDP. 1 2 The Income Approach MyLab
Economics Concept Check We now turn to calculating GDP using the income approach, which looks at GDP in terms of who receives it as income rather than as who purchases it. We begin with the concept of national income, which is defined in Table 6.3. National income is the sum of eight income items. Compensation of employees, the largest of the eight items by far, includes wages and salaries paid to households by firms and by the government, as well as various supplements to wages and salaries such as contributions that employers make to social insurance and private pension funds. Proprietors’ income is the income of unincorporated businesses. Rental income, a minor item, is the income received by property owners in the form of rent. Corporate profits, the second-largest item of the eight, is the income of corporations. Net interest is the interest paid by business. (Interest paid by households and the government is not counted in GDP because it is not assumed to flow from the production of goods and services.) The sixth item, indirect taxes minus subsidies, includes taxes such as sales taxes, customs duties, and license fees less subsidies that the government pays for which it receives no goods or services in return. (Subsidies are like negative taxes.) The value of indirect taxes minus subsidies is thus net revenue received by the government. Net business transfer payments are net transfer payments by businesses to others and are thus income of others. The final item is the surplus of government enterprises, which is the income of government enterprises. Table 6.3 shows that this item was negative in 2017: government enterprises on net ran at a loss. National income is the total income of the country, but it is not quite GDP. Table 6.4 shows what is involved in going from national income to GDP. Table 6.4 first shows that in moving from GDP to GNP, we need to add receipts of factor income from the rest of the world and subtract payments of factor income to the rest of the world. National income is income of the country’s citizens, not the income of the residents of the country. So we first need to move from GDP to GNP. This, as discussed previously, is a minor adjustment. TABLE 6.3 National Income, 2017 National income Compensation of employees Proprietors’ income Rental income Corporate profits Net interest Indirect taxes minus subsidies Net business transfer payments Surplus of government enterprises Billions of Dollars ($) Percentage of National Income (%) 16,607.7 100.0 10,307.2 1
,386.0 743.9 2,164.6 586.4 1,268.8 161.8 −11.0 62.1 8.3 4.5 13.0 3.5 7.6 1.0 −0.1 Source: U.S. Bureau of Economic Analysis, March 28, 2018. M06_CASE3826_13_GE_C06.indd 138 17/04/19 12:16 AM CHAPTER 6 Measuring National Output and National Income 139 TABLE 6.4 GDP, GNP, NNP, and National Income, 2017 GDP Plus: Receipts of factor income from the rest of the world Less: Payments of factor income to the rest of the world Equals: GNP Less: Depreciation Equals: Net national product (NNP) Less: Statistical discrepancy Equals: National income Source: U.S. Bureau of Economic Analysis, March 28, 2018. Billions of Dollars ($) 19,390.6 +934.7 -717.9 19,607.4 -3,034.7 16,572.7 -( -35.0) 16,607.7 We then need to subtract depreciation from GNP, which is a large adjustment. GNP less depreciation is called net national product (NNP). Why is depreciation subtracted? To see why, go back to the example previously in this chapter in which the economy is made up of just one firm and total output (GDP) for the year is $1 million. Assume that after the firm pays wages, interest, and rent, it has $100,000 left. Assume also that its capital stock depreciated by $40,000 during the year. National income includes corporate profits (see Table 6.3), and in calculating corporate profits, the $40,000 depreciation is subtracted from the $100,000, leaving profits of $60,000. So national income does not include the $40,000. When we calculate GDP using the expenditure approach, however, depreciation is not subtracted. We simply add consumption, investment, government spending, and net exports. In our simple example, this is just $1 million. We thus must subtract depreciation from GDP (actually GNP when there is a rest-of-the-world sector) to get national income. Table 6.4 shows that net national product and national income are the same except for a statistical discrepancy, a data measurement error.
If the government were completely accurate in its data collection, the statistical discrepancy would be zero. The data collection, however, is not perfect, and the statistical discrepancy is the measurement error in each period. Table 6.4 shows that in 2017, this error was –$35.0 billion, which is small compared to national income of $16,607.7 billion. We have so far seen from Table 6.3 the various income items that make up total national income, and we have seen from Table 6.4 how GDP and national income are related. A useful way to think about national income is to consider how much of it goes to households. The total income of households is called personal income, and it turns out that almost all of national income is personal income. Table 6.5 shows that of the $16,607.7 billion in national income in 2017, $16,427.3 billion was personal income. The second line in Table 6.5, the amount of national income not going to households, includes the profits of corporations not paid to households in the form of dividends, called the retained earnings of corporations. This is income that stays inside corporations for some period rather than going to households, and so it is part of national income but not personal income. TABLE 6.5 National Income, Personal Income, Disposable Personal Income, and Personal Saving, 2017 National income Less: Amount of national income not going to households Equals: Personal income Less: Personal income taxes Equals: Disposable personal income Less: Personal consumption expenditures Personal interest payments Transfer payments made by households Equals: Personal saving Personal saving as a percentage of disposable personal income: Source: U.S. Bureau of Economic Analysis, March 28, 2018. Billions of Dollars ($) 16,607.7 - 180.4 16,427.3 - 2,048.3 14,379.0 - 13,395.5 - 300.5 - 197.0 485.9 3.4% net national product (NNP) Gross national product minus depreciation; a nation’s total product minus what is required to maintain the value of its capital stock. statistical discrepancy Data measurement error. personal income The total income of households. M06_CASE3826_13_GE_C06.indd 139 17/04/19 12:16 AM 140 PART II Concepts and Problems in Macroeconomics disposable personal income or after-tax income Personal income minus personal income taxes. The amount that households have to spend
or save. personal saving The amount of disposable income that is left after total personal spending in a given period. personal saving rate The percentage of disposable personal income that is saved. If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiously. 6.3 LEARNING OBJECTIVE Discuss the difference between real GDP and nominal GDP. current dollars The current prices that we pay for goods and services. nominal GDP Gross domestic product measured in current dollars. weight The importance attached to an item within a group of items. Personal income is the income received by households before they pay personal income taxes. The amount of income that households have to spend or save is called disposable personal income, or after-tax income It is equal to personal income minus personal income taxes, as shown in Table 6.5. Because disposable personal income is the amount of income that households can spend or save, it is an important income concept. Table 6.5 shows there are three categories of spending: (1) personal consumption expenditures, (2) personal interest payments, and (3) transfer payments made by households. The amount of disposable personal income left after total personal spending is personal saving. If your monthly disposable income is $500 and you spend $450, you have $50 left at the end of the month. Your personal saving is $50 for the month. Your personal saving level can be negative: If you earn $500 and spend $600 during the month, you have dissaved $100. To spend $100 more than you earn, you will have to borrow the $100 from someone, take the $100 from your savings account, or sell an asset you own. The personal saving rate is the percentage of disposable personal income saved, an important indicator of household behavior. A low saving rate means households are spending a large fraction of their income. As Table 6.5 shows, the U.S. personal saving rate in 2017 was 3.4 percent. Saving rates tend to rise during recessionary periods, when consumers become anxious about their future, and fall during boom times, as pent-up spending demand gets released. In 2005 the saving rate got down to 2.5 percent. Nominal versus Real GDP We have thus far looked at GDP measured in current dollars, or the current prices we pay for goods and services. When we measure something in current dollars, we refer to it as a nominal value. Nominal GDP is GDP measured in current dollars—all
components of GDP valued at their current prices. In most applications in macroeconomics, however, nominal GDP is not what we are after. It is not a good measure of aggregate output over time. Why? Assume that there is only one good—say, pizza, which is the same quality year after year. In each year 1 and 2, one hundred units (slices) of pizza were produced. Production thus remained the same for year 1 and year 2. Suppose the price of pizza increased from $1.00 per slice in year 1 to $1.10 per slice in year 2. Nominal GDP in year 1 is $100 (100 units * +1.00 per unit), and nominal GDP in year 2 is $110 (100 units * +1.10 per unit). Nominal GDP has increased by $10 even though no more slices of pizza were produced and the quality of the pizza did not improve. If we use nominal GDP to measure growth, we can be misled into thinking production has grown when all that has really happened is a rise in the price level (inflation). If there were only one good in the economy—for example, pizza—it would be easy to measure production and compare one year’s value to another’s. We would add up all the pizza slices produced each year. In the example, production is 100 in both years. If the number of slices had increased to 105 in year 2, we would say production increased by 5 slices between year 1 and year 2, which is a 5 percent increase. Alas, however, there is more than one good in the economy which makes adjusting for price changes more complex. The following is a discussion of how the BEA adjusts nominal GDP for price changes. As you read the discussion, you will see that this adjustment is not easy. Even in an economy of just apples and oranges, it would not be obvious how to add up apples and oranges to get an overall measure of output. The BEA’s task is to add up thousands of goods, each of whose price is changing over time. In the following discussion, we will use the concept of a weight, either price weights or quantity weights. What is a weight? It is easiest to define the term by an example. Suppose in your economics course there is a final exam and two other tests. If the final exam counts for one-half of the grade and the other two tests for one-fourth each, the “weights” are one
-half, onefourth, and one-fourth. If instead the final exam counts for 80 percent of the grade and the other two tests for 10 percent each, the weights are 0.8, 0.1, and 0.1. The more important an item is in a group, the larger its weight. M06_CASE3826_13_GE_C06.indd 140 17/04/19 12:16 AM GDP: One of the Great Inventions of the 20th Century CHAPTER 6 Measuring National Output and National Income 141 As the 20th century drew to a close, the U.S. Department of Commerce embarked on a review of its achievements. At the conclusion of this review, the Department named the development of the national income and product accounts as “its achievement of the century.” J. Steven Landefeld Director, Bureau of Economic Analysis While the GDP and the rest of the national income accounts may seem to be arcane concepts, they are truly among the great inventions of the twentieth century. Paul A. Samuelson and William D. Nordhaus GDP! The right concept of economy-wide output, accurately measured. The U.S. and the world rely on it to tell where we are in the business cycle and to estimate long-run growth. It is the centerpiece of an elaborate and indispensable system of social accounting, the national income and product accounts. This is surely the single most innovative achievement of the Commerce Department in the 20th century. I was fortunate to become an economist in the 1930s when Kuznets, Nathan, Gilbert, and Jaszi were creating this most important set of economic time series. In economic theory, macroeconomics was just beginning at the same time. Complementary, these two innovations deserve much credit for the improved performance of the economy in the second half of the century. James Tobin From The Survey of Current Business Prior to the development of the NIPAs [national income and product accounts], policy makers had to guide the economy using limited and fragmentary information about the state of the economy. The Great Depression underlined the problems of incomplete data and led to the development of the national accounts: One reads with dismay of Presidents Hoover and then Roosevelt designing policies to combat the Great Depression of the 1930s on the basis of such sketchy data as stock price indices, freight car loadings, and incomplete indices of industrial production. The fact was that comprehensive measures of national income and output did not exist at the time. The Depression
, and with it the growing role of government in the economy, emphasized the need for such measures and led to the development of a comprehensive set of national income accounts. Richard T. Froyen In response to this need in the 1930s, the Department of Commerce commissioned Nobel laureate Simon Kuznets of the National Bureau of Economic Research to develop a set of national economic accounts.... Professor Kuznets coordinated the work of researchers at the National Bureau of Economic Research in New York and his staff at Commerce. The original set of accounts was presented in a report to Congress in 1937 and in a research report, National Income, 1929–35. The national accounts have become the mainstay of modern macroeconomic analysis, allowing policy makers, economists, and the business community to analyze the impact of different tax and spending plans, the impact of oil and other price shocks, and the impact of monetary policy on the economy as a whole and on specific components of final demand, incomes, industries, and regions. CRITICAL THINKING 1. The articles emphasize the importance of being able to measure an economy’s output to improve government policy. Looking at recent news, can you identify one economic policy debate or action that referenced GDP? Source: U.S. Department of Commerce, Bureau of Economic Analysis, Washington, DC.” Survey of Current Business, January 2000, pp. 6–9. M06_CASE3826_13_GE_C06.indd 141 17/04/19 12:16 AM 142 PART II Concepts and Problems in Macroeconomics Calculating Real GDP MyLab Economics Concept Check Nominal GDP adjusted for price changes is called real GDP. All the main issues involved in computing real GDP can be discussed using a simple three-good economy and 2 years. Table 6.6 presents all the data that we will need. The table presents price and quantity data for 2 years and three goods. The goods are labeled A, B, and C, and the years are labeled 1 and 2. P denotes price, and Q denotes quantity. Keep in mind that everything in the following discussion, including the discussion of the GDP deflation, is based on the numbers in Table 6.6. Nothing has been brought in from the outside. The table is the entire economy. The first thing to note from Table 6.6 is that nominal output—in current dollars—in year 1 for good A is the number of units of good A produced in year 1 (6) times the price of good
A in year 1 ($0.50), which is $3.00. Similarly, nominal output in year 1 is 7 * +0.30 = +2.10 for good B and 10 * +0.70 = +7.00 for good C. The sum of these three amounts, $12.10 in column 5, is nominal GDP in year 1 in this simple economy. Nominal GDP in year 2—calculated by using the year 2 quantities and the year 2 prices—is $19.20 (column 8). Nominal GDP has risen from $12.10 in year 1 to $19.20 in year 2, an increase of 58.7 percent.3 You can see that the price of each good changed between year 1 and year 2—the price of good A fell (from $0.50 to $0.40) and the prices of goods B and C rose (B from $0.30 to $1.00; C from $0.70 to $0.90). Some of the change in nominal GDP between years 1 and 2 is as a result of price changes and not production changes. How much can we attribute to price changes and how much to production changes? Here things get tricky. The procedure that the BEA used before 1996 was to pick a base year and to use the prices in that base year as weights to calculate real GDP. This is a fixed-weight procedure because the weights used, which are the prices, are the same for all years—namely, the prices that prevailed in the base year. Let us use the fixed-weight procedure and year 1 as the base year, which means using year 1 prices as the weights. Then in Table 6.6, real GDP in year 1 is $12.10 (column 5) and real GDP in year 2 is $15.10 (column 6). Note that both columns use year 1 prices and that nominal and real GDP are the same in year 1 because year 1 is the base year. Real GDP has increased from $12.10 to $15.10, an increase of 24.8 percent. Let us now use the fixed-weight procedure and year 2 as the base year, which means using year 2 prices as the weights. In Table 6.6, real GDP in year 1 is $18.40 (column 7) and real GDP in year 2 is $19.20 (column 8). Note that both columns use year 2 prices and that nominal and real GDP are
the same in year 2, because year 2 is the base year. Real GDP has increased from $18.40 to $19.20, an increase of 4.3 percent. This example shows that growth rates can be sensitive to the choice of the base year—24.8 percent using year 1 prices as weights and 4.3 percent using year 2 prices as weights. For many policy decisions, the growth rates of the economy play an important role so that large differences coming from a seemingly arbitrary choice of base year is troubling. The old BEA procedure base year The year chosen for the weights in a fixed-weight procedure. fixed-weight procedure A procedure that uses weights from a given base year. TABLE 6.6 A Three-Good Economy (1) (2) (3) (4) (5) (6) (7) (8) Production Price per Unit Year 1 Q1 Year 2 Q2 Year 1 P1 Year 2 P2 6 7 10 11 4 12 $0.50 0.30 0.70 $0.40 1.00 0.90 Good A Good B Good C Total GDP in Year 1 in Year 1 Prices P1 * Q1 GDP in Year 2 in Year 1 Prices P1 * Q2 GDP in Year 1 in Year 2 Prices P2 * Q1 GDP in Year 2 in Year 2 Prices P2 * Q2 $ 3.00 2.10 7.00 $12.10 Nominal GDP in Year 1 $ 5.50 1.20 8.40 $15.10 $ 2.40 7.00 9.00 $18.40 $ 4.40 4.00 10.80 $19.20 Nominal GDP in Year 2 3The percentage change is calculated as [(19.20 - 12.10) 12.10] * 100 =.587 * 100 = 58.7 percent. > M06_CASE3826_13_GE_C06.indd 142 17/04/19 12:16 AM CHAPTER 6 Measuring National Output and National Income 143 simply picked one year as the base year and did all the calculations using the prices in that year as weights. The new BEA procedure makes two important changes. The first (using the current example) is to take the average of the two years’ price changes, in other words, to “split the difference” between 24.8 percent and 4.3 percent. What does “splitting the difference” mean? One
way is to take the average of the two numbers, which is 14.55 percent. What the BEA does is to take the geometric average, which for the current example is 14.09 percent.4 These two averages (14.55 percent and 14.09 percent) are quite close, and the use of either would give similar results. The point here is not that the geometric average is used, but that the first change is to split the difference using some average. When prices are going up, this procedure will lower the estimates of real growth rates relative to the use of year 1 as a base year, and conversely when prices are falling. Note that this new procedure requires two “base” years because 24.8 percent was computed using year 1 prices as weights and 4.3 percent was computed using year 2 prices as weights. The second BEA change is to use years 1 and 2 as the base years when computing the percentage change between years 1 and 2, then use years 2 and 3 as the base years when computing the percentage change between years 2 and 3, and so on. The two base years change as the calculations move through time. The series of percentage changes computed this way is taken to be the series of growth rates of real GDP. So in this way, nominal GDP is adjusted for price changes. To make sure you understand this, review the calculations in Table 6.6, which provides all the data you need to see what is going on. Calculating the GDP Deflator MyLab Economics Concept Check We now switch gears from real GDP, a quantity measure, to the GDP deflator, a price measure. One of economic policy makers’ goals is to keep changes in the overall price level small. For this reason, policy makers not only need good measures of how real output is changing but also good measures of how the overall price level is changing. The GDP deflator is one measure of the overall price level. We can use the data in Table 6.6 to show how the BEA computes the GDP deflator. In Table 6.6, the price of good A fell from $0.50 in year 1 to $0.40 in year 2, the price of good B rose from $0.30 to $1.00, and the price of good C rose from $0.70 to $0.90. If we are interested only in how individual prices change, this is all the information we need. However, if we are interested in how the overall
price level changes, we need to weight the individual prices in some way. Is it getting more expensive to live in this economy or less expensive? In this example that clearly depends on how people spend their incomes. So, the obvious weights to use are the quantities produced, but which quantities—those of year 1 or year 2? The same issues arise here for the quantity weights as for the price weights in computing real GDP. Let us first use the fixed-weight procedure and year 1 as the base year, which means using year 1 quantities as the weights. Then in Table 6.6, the “bundle” price in year 1 is $12.10 (column 5) and the bundle price in year 2 is $18.40 (column 7). Both columns use year 1 quantities. The bundle price has increased from $12.10 to $18.40, an increase of 52.1 percent. Next, use the fixed-weight procedure and year 2 as the base year, which means using year 2 quantities as the weights. Then the bundle price in year 1 is $15.10 (column 6), and the bundle price in year 2 is $19.20 (column 8). Both columns use year 2 quantities. The bundle price has increased from $15.10 to $19.20, an increase of 27.2 percent. This example shows that overall price increases can be sensitive to the choice of the base year: 52.1 percent using year 1 quantities as weights and 27.2 percent using year 2 quantities as weights. Again, the old BEA procedure simply picked one year as the base year and did all the calculations using the quantities in the base year as weights. First, the new procedure splits the difference between 52.1 percent and 27.2 percent by taking the geometric average, which is 39.1 percent. Second, it uses years 1 and 2 as the base years when computing the percentage change between years 1 and 2, years 2 and 3 as the base years when computing the percentage change between years 2 and 3, and so on. The series of percentage changes computed this way is taken to be the series of percentage changes in the GDP deflator, that is, a series of inflation rates. 4The geometric average is computed as the square root of 124.8 * 104.3, which is 114.09. M06_CASE3826_13_GE_C06.indd 143 17/04/19 12:16 AM 144 PART II Concepts and

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