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calculate the values for each quantity of total product. Supply 145 S E C T I O N 3 What Factors Affect Supply TA K I N G N O T E S In Section 3, you will change in quantity supplied, p. 146 • explain the difference between change in quantity supplied and change in supply • understand how to determine a change in supply • identify the factors that can cause a change in supply change in supply, p. 148 input costs, p. 148 labor productivity, p. 149 technology, p. 149 excise tax, p. 149 regulation, p. 150 As you read Section 3, complete a chart like this one showing each factor that causes change in supply. Use the Graphic Organizer at Interactive Review @ ClassZone.com Factor That Changes Supply Reason Why Supply Changes Changes in Quantity Supplied KEY CONCEPT S The supply schedules and supply curves that you studied in Section 1 were created using the assumption that all other economic factors except the price of tomatoes would remain the same. If all other factors remain the same, then the only thing that influences how many tomatoes producers will offer for sale is the price of those tomatoes. The supply curve shows that pattern. In Chapter 4, you learned the difference between change in demand and change in quantity demanded. Change in quantity demanded is shown by the points along an existing demand curve, while change in demand actually shifts the demand curve itself. Similarly, the different points on a supply curve show change in quantity supplied. Change in quantity supplied is an increase or decrease in the amount of a good or service that producers are willing to sell because of a change in price. QUICK REFERENCE Change in quantity supplied is a rise or fall in the amount producers offer for sale because of a change in price. A change in the price of bicycles...... causes a change in the quantity supplied. 146 Chapter 5 E XAMPLE Changes Along a Supply Curve Each new point on the supply curve shows a change in quantity supplied. A change in quantity supplied does not shift the supply curve itself. Let’s look again at the Smiths’ supply curve for tomatoes (Figure 5.10). Note the quantities supplied at each price. Notice that as quantity supplied changes, the change is shown by the direction of movement, right or left, along the supply curve. A movement to the right indicates an increase in both price and quantity supplied. A movement to the left shows a decrease in both price and quantity supplied. FIGURE 5.10 CHANGES IN QUANTITY SUP
PLIED 2.00 1.75 1.50 1.25 1.00.75.50.25 ) change in quantity supplied doesn’t shift the supply curve. The change refers to movement along the curve itself. Each point on the curve represents a new quantity supplied. a As you move to the right along the curve, the quantity supplied increases. b As you move to the left along the curve, the quantity supplied decreases. 10 0 Quantity supplied of tomatoes (in pounds) 20 50 30 40 ANALYZE GRAPHS 1. What is the change in quantity supplied when price increases from $0.75 to $1.50? 2. What is the change in price when quantity supplied changes from 50 to 24 pounds? Use an interactive supply curve to see changes in quantity supplied at ClassZone.com Just as Figure 5.10 shows change in quantity supplied by one individual, a market supply curve shows similar information for an entire market. However, market supply curves have larger quantities supplied, and therefore larger changes to quantity supplied, because they combine the data from all the individual supply curves in the market. For example, when the price increases from $0.75 to $1.75 on the market supply curve (Figure 5.5), the quantity supplied increases from 100 pounds to 300. Compare this with the change in quantity supplied at those prices in Figure 5.10. AP P LI CATION Applying Economic Concepts A. Changes in quantity supplied do not shift the position of the supply curve. Why? Supply 147 Changes in Supply KEY CONCEPT S QUICK REFERENCE Change in supply occurs when a change in the marketplace prompts producers to sell different amounts at every price. Consider what might happen if the workers at an automobile factory negotiate a large wage increase so that it’s more expensive to produce each automobile. As the firm’s costs increase, it is less willing and able to offer as many automobiles for sale. Any action such as this, which changes the costs of production, will change supply. Change in supply occurs when something prompts producers to offer different amounts for sale at every price. When production costs increase, supply decreases; when production costs decrease, supply increases. Just like change in demand, change in supply actually shifts the supply curve. Six factors cause a change in supply: input costs, labor productivity, technology, government actions, producer expectations, and number of producers. FACTOR 1 Input Costs QUICK REFERENCE Input costs are the price of the resources used to make
products. Input costs are a major factor that affects production costs and, therefore, supply. Input costs are the price of the resources needed to produce a good or service. For example, Anna makes nutrition bars that contain peanuts. If the price of peanuts increases, Anna’s costs increase. She cannot afford to produce as many nutrition bars, and her supply curve shifts to the left (Figure 5.11). When the price of peanuts decreases, her costs decrease. She is willing and able to increase the quantity she can supply at every price, and the curve shifts to the right (Figure 5.12). FIGURES 5.11 AND 5.12 SHIFTS IN SUPPLY FIGURE 5.11 DECREASE IN SUPPLY FIGURE 5.12 INCREASE IN SUPPLY ) S2 a S1 10 20 30 40 50 60 ) S1 S3 b 10 20 30 40 50 60 Quantity supplied of nutrition bars Quantity supplied of nutrition bars ANALYZE GRAPHS 1. In Figure 5.11, how has the supply of nutrition bars changed at every price? 2. In Figure 5.12, how has the supply of nutrition bars changed at every price? Use an interactive version of shifting supply curves at ClassZone.com 148 Chapter 5 When a change in supply occurs, the supply curve shifts. a As Figure 5.11 shows, a shift to the left (S2) indicates a decrease in supply. b As Figure 5.12 shows, a shift to the right (S3) indicates an increase in supply. FACT OR 2 Labor Productivity Labor productivity is the amount of goods and services that a person can produce in a given time. Increasing productivity decreases the costs of production and therefore increases supply. For example, a specialized division of labor can allow a producer to make more goods at a lower cost, as was the case at Janine’s factory in Section 2. Her marginal costs decreased when there were six workers, each of whom had a separate job to do. Better-trained and more-skilled workers can usually produce more goods in less time, and therefore at lower costs, than less-educated or less-skilled workers. For example, a business that provides word-processing services can produce more documents if its employees type quickly and have a lot of experience working with wordprocessing software. QUICK REFERENCE Labor productivity is the amount of goods and services that a person can produce in a given time. Technology entails applying scientific methods and innovations to production.
FACT OR 3 Technology One way that businesses improve their productivity and increase supply is through the use of technology. Technology involves the application of scientific methods and discoveries to the production process, resulting in new products or new manufacturing techniques. Influenced by the profit motive, manufacturers have, throughout history, used technology to make goods more efficiently. Increased automation, including the use of industrial robots, has led to increased supplies of automobiles, computers, and many other products. (See the Case Study on pages 158–159.) The Typewriter’s End The move from typewriter to computer shows how technology helps to boost productivity. Improved technology helps farmers produce more food per acre. It also allows oil refiners to get more gasoline out of every barrel of crude oil and helps to get that gasoline to gas stations more quickly and more safely. In addition, technological innovations, such as the personal computer, enable workers to be more productive. This, in turn, helps businesses to increase the supply of their services, such as processing insurance claims or selling airline tickets. FACT OR 4 Government Action Government actions can also affect the costs of production, both positively and negatively. An excise tax is a tax on the production or sale of a specific good or service. Excise taxes are often placed on items such as alcohol and tobacco— things whose consumption the government is interested in discouraging. The taxes increase producers’ costs and, therefore, decrease the supply of these items. Taxes tend to decrease supply; subsidies have the opposite effect. You learned in Chapter 3 that a subsidy is a government payment that partially covers the cost of an economic activity. The subsidy’s purpose is to encourage or protect that activity. Most forms of energy production in the United States receive some form of subsidy. For example, subsidies helped to double the supply of ethanol, a gasoline substitute made from corn, between 2000 and 2004. QUICK REFERENCE An excise tax is a tax on the making or selling of certain goods or services. Supply 149 QUICK REFERENCE Regulation is a set of rules or laws designed to control business behavior. Government regulation, the act of controlling business behavior through a set of rules or laws, can also affect supply. Banning a certain pesticide might decrease the supply of the crops that depend on the pesticide. Worker safety regulations might decrease supply by increasing a business’s production costs or increase supply by reducing the amount of labor lost to on-the-job injuries. FACTOR 5 Producer Expectations If producers expect the price of their product to
rise or fall in the future, it may affect how much of that product they are willing and able to supply in the present. Different kinds of producers may react to future price changes differently. For example, if a farmer expects the price of corn to be higher in the future, he or she may store some of the current crop, thereby decreasing supply. A manufacturer who believes the price of his or her product will rise may run the factory for an extra shift or invest in more equipment to increase supply. FACTOR 6 Number of Producers When one company develops a successful new idea, whether it’s designer wedding gowns, the latest generation of cell phones, or fast-food sushi, other producers soon enter the market and increase the supply of the good or service. When this happens, the supply curve shifts to the right, as you can see in Figure 5.13. FIGURE 5.13 NUMBER OF PRODUCERS 3.00 ).50 2.00 1.50 1.00.50 S1 S2 a b a This supply curve (S1) shows the number of ice cream cones sold in a week at each price when Casey is the only supplier in the market. b This curve (S2) shows the number of ice cream cones sold in a week at each price when three more suppliers enter the market. 0 50 100 150 200 250 300 Quantity supplied of ice cream cones ANALYZE GRAPHS 1. About how many ice cream cones were sold at $1.00 when Casey was the only producer in the market? 2. How do these two curves show the effect of the number of producers on the supply of ice cream cones in the market? An increase in the number of producers means increased competition, which may eventually drive less-efficient producers out of the market, decreasing supply. (You’ll learn more about competition in Chapter 7.) Competition has a major impact on supply, as producers enter and leave the market constantly. 150 Chapter 14 Factors That Cause a Change in Supply Input Costs Input costs, the collective price of the resources that go into producing a good or service, affect supply directly. Number of Producers A successful new product or service always brings out competitors who initially raise overall supply. Producer Expectations The amount of product producers are willing and able to supply may be influenced by whether they believe prices will go up or down. What Causes a Change in Supply? Government Action Government actions, such as taxes or subsidies, can have a positive or a negative effect
on production costs. Labor Productivity Better-trained or more-skilled workers are usually more productive. Increased productivity decreases costs and increases supply. Technology By applying scientific advances to the production process, producers have learned to generate their goods and services more efficiently. ANALYZE CHARTS A newspaper article states that the supply of snowboards has risen dramatically over the past six months. Choose four of the six factors that cause a change in supply and explain how each might have resulted in the recent influx of snowboards. Figure 5.13 shows what happens to the supply of ice cream cones in a neighborhood as more producers enter the market. When Casey opened his ice cream store it was the only one in the area. It was an instant success. Within six months, three competing stores had opened in the neighborhood, and the supply of ice cream cones increased at all price levels. A year later, though, this intense competition forced one of the producers to leave the market. AP P LI CATION Applying Economic Concepts B. Choose an item of food or clothing that you buy regularly. List as many input costs as you can that might affect the supply of that product. Compare your list with a classmate’s and see if you can add to each other’s lists. Supply 151 ECO N O M I C S PAC ES E T T E R Robert Johnson: Supplying AfricanAmerican Entertainment In this section, you’ve learned about the factors that influence supply. You’ve also seen some examples of how these factors work. The story of media entrepreneur Robert Johnson provides a real-world example of how the entrance of a new supplier can affect a market. EXAMPLE Expanding the Number of Producers In the late 1970s, Robert Johnson was working as a Washington lobbyist for the National Cable Television Association. He recognized that current suppliers in the cable TV industry were ignoring a substantial market—African Americans. To fill this void, Johnson conceived the idea for Black Entertainment Television (BET), the first cable channel owned by and focused on African Americans. To launch his dream, Johnson took out a $15,000 bank loan. He also persuaded a major investor to put up $500,000. Next, he secured space on a cable TV satellite for his new channel. BET’s first program appeared on January 8, 1980. The company grew from offering two hours of programming a week to round-the-clock programming on five separate channels. Cable operators in the United States, Canada, and the Caribbean saw the
value of this kind of targeted programming, and began to buy BET’s shows. A Vast Reach BET supplies programming to more than 80 million households in Canada, the United States, and the Caribbean. At first, BET targeted young viewers with programs similar to those on MTV. As the cable TV industry grew and became more profitable, Johnson invested in more diverse programming. Of this transition he explained, “Now we’re a music video channel with a public affairs footprint....” BET could “play music, but also... cover issues that are of concern to African Americans.” BET.com, the number one Internet portal for African Americans, soon followed. In 2001, Johnson sold BET to the giant media company Viacom International Inc. for $3 billion and became the nation’s first black billionaire. After the sale, Johnson stayed on at BET and continued to run the company for five more years. His success demonstrated that there was a strong market for African-American entertainment. As a result, many suppliers—some with no traditional ties to the African-American community— now offer the kind of programming Johnson pioneered. APPLICATION Making Inferences C. What effects might BET’s success have on the supply of African-American programming? FAST FACTS Robert Johnson Title: Chairman of BET Holdings II, Inc., retired Born: April 8, 1946, Hickory, Mississippi Major Accomplishment: BET is the leading supplier of cable TV programming aimed at African Americans. Other Enterprises: Digital music networks, publishing, events production, BET.com Web portal, NBA team Charlotte Bobcats, and WNBA Charlotte Sting Honors: Broadcasting and Cable Magazine Hall of Fame Award, NAACP Image Award Find an update on Robert Johnson at ClassZone.com 152 Chapter 5 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. change in quantity supplied change in supply b. input costs technology c. excise tax regulation 2. What else besides raw materials would be included in input costs? 3. Why might an increase in oil prices lead to a decrease in the supply of fruits and vegetables in your local supermarket? 4. Why do excise taxes and subsidies affect supply differently? 5. Does expectation of a change in price affect supply? Illustrate your answer with examples. Factor That Changes Supply Reason Why Supply Changes 6. Using Your Notes How does a change in number of producers affect
supply? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com. Applying Economic Concepts How do each of these examples of government actions affect the supply of gasoline? a. In 2005, the government continued support for ethanol, a gasoline substitute. b. The state of California requires a special blend of gasoline that meets stricter environmental standards than other regions in the country. c. Many states use gasoline taxes to help fund highway construction and maintenance. 8. Making Inferences Why do you think governments want to influence the supply of alcohol and tobacco products by imposing excise taxes? 9. Analyzing Effects Take out the market supply curve for skis that you created on page 137. Add new curves showing how supply would be changed in each of the following cases. Share your graph with a classmate and explain your reasoning. a. The price of titanium, used in skis, declines dramatically. b. A large manufacturer decides to stop producing skis. 10. Challenge How does an increased number of producers affect the prices of goods in a market? What is the reason for this effect? Think about what you know about demand and supply and review Figure 5.12 as you formulate your answer. Explaining Changes in Supply Suppose that you are a manufacturer of personal digital music players (PDMPs). What factors affect supply for PDMPs? The chart below lists examples of a change in supply in the market for PDMPs. For each example, identify which factor that affects supply is involved and state whether supply increases or decreases. Factor and How It Affected Supply Example of Change That Affects Supply You give each worker in your factory a specialized job. Price of computer chips used in PDMPs rises. New machinery speeds up the manufacturing process. Your success prompts three new companies to start producing PDMPs. A new law requires producers to recycle the wastewater from their factories. Challenge Identify which of the six factors that affect supply does not appear on this chart. What would be an example of how that factor might affect the market for PDMPs? Supply 153 S E C T I O N 4 What Is Elasticity of Supply TA K I N G N O T E S In Section 4, you will elasticity of supply, p. 154 • define the term elasticity of supply • explain the difference between elastic and inelastic supply • identify the factors that affect elasticity of supply As you read Section 4, complete a cluster diagram like the one shown. Use the Graphic Organizer at Interactive Review @
ClassZone.com Elasticity of Supply Elasticity of Supply KEY CONCEPT S According to the law of supply, as price increases so will the supply of a good or service. When Toyota Motor Corporation introduced its Prius hybrid in 2000, it was surprised by the automobile’s instant popularity. Consumers were willing to pay more than the manufacturer’s suggested price. Yet Toyota was not able to increase supply at the same pace that consumer demand and prices rose. Even five years later, Toyota could not meet rising demand. This inability to effectively respond to and meet increased demand suggests that the supply of the Prius was inelastic. In Chapter 4, you learned that elasticity of demand measures how responsive consumers are to price changes. In a similar way, elasticity of supply is also a measure of how responsive producers are to price changes. If a change in price leads to a relatively larger change in quantity supplied, supply is said to be elastic. In other words, supply is elastic if a 10 percent increase in price causes a greater than 10 percent increase in quantity supplied. If a change in price leads to a relatively smaller change in quantity supplied, supply is said to be inelastic. If the price and the quantity supplied change by exactly the same percentage, supply is unit elastic. Inelastic Supply The supply of expensive and complicated items, such as this Prius hybrid, is often inelastic. QUICK REFERENCE Elasticity of supply is a measure of how responsive producers are to price changes in the marketplace. 154 Chapter 5 E XAMPLE Elastic Supply Let’s look at an example of elastic supply. Figure 5.15 illustrates how the quantity supplied of a new style of leather boots was elastic. As the boots gained in popularity, a shortage developed. The boot makers raised the price of the boots from $60 to $150 dollars, and the quantity supplied more than kept up, escalating from 10,000 to 50,000 pairs. The producer was able to rapidly increase the quantity supplied because, unlike car manufacturing for instance, the raw materials needed to make boots are neither particularly expensive nor hard to come by. The actual manufacturing process is also, relatively speaking, fairly uncomplicated and easy to increase. E XAMPLE Inelastic Supply In Chapter 4, you learned that demand for gasoline was inelastic. The supply of gasoline is also inelastic. Although gasoline prices rose 20 to 30 percent between 2004 and 2005, producers were not able to increase supply by the same amount because of
the limited supply of crude oil and refining capacity. Figure 5.16 shows how the supply of olive oil is also inelastic. When the price of olive oil rose by a factor of four, supply could not keep pace, as the oil comes from the previous season’s olives and is exported from the Mediterranean region. FIGURE 5.15 ELASTIC SUPPLY CURVE FIGURE 5.16 INELASTIC SUPPLY CURVE a 150 120 90 60 30 ) 10 20 30 40 50 Quantity supplied of boots (in thousands 10 20 30 40 50 Quantity supplied of olive oil (in thousands of gallons) a The curve in Figure 5.15 slopes gradually. It slopes more horizontally than vertically because of greater changes in quantity supplied. b The curve in Figure 5.16 slopes steeply. It slopes more vertically than horizontally because of lesser changes in quantity supplied. ANALYZE GRAPHS 1. If the price of leather rose dramatically for the boots in Figure 5.15, how might this affect elasticity of supply? 2. In the United States, would the supply of corn oil be more elastic than the supply of olive oil? Why or why not? Use elastic and inelastic supply curves at ClassZone.com AP P LI CATION Drawing Conclusions A. A bakery produces 200 muffins per week that sell for $1.50 each. When the price increases to $2.00, it produces 300 muffins per week. Is supply elastic or inelastic? Explain your answer. Supply 155 What Affects Elasticity of Supply? KEY CONCEPT S Just as there are factors that cause a change in supply, there are also factors that affect the elasticity of supply. There are far fewer of these factors than for elasticity of demand. The ease of changing production to respond to price change is the main factor in determining elasticity of supply. Given enough time, the elasticity of supply increases for most goods and services. Supply will be more elastic over a year or several years than it will be if the time frame to respond is a day, a week, or a month. Industries that are able to respond quickly to changes in price by either increasing or decreasing production are those that don’t require a lot of capital, skilled labor, or difficult-to-obtain resources. For example, the quantity supplied of dog-walking services can increase rapidly with the addition of more people to walk dogs. A small business that sells crafts made from recycled
materials would be able to respond quickly to changes in the price of its various products by applying its resources to increase the supply of its higher priced items. For other industries, it takes a great deal of time to shift the resources of production to respond to price changes. Automakers and oil refiners are examples of industries that rely on large capital outlays or difficult-to-obtain resources. It might take such suppliers a considerable amount of time to respond to price changes. YO U R EC STIC IT Y O F SU PPLY Which supply of cupcakes is more elastic? You’re planning to sell cupcakes at your school’s football game to raise funds for a charitable cause, but it’s hard to say in advance how many fans will attend the game. You can place an order with a bakery (which you need to do a week early) or have volunteers do the baking the night before the game. Which supply of cupcakes is more elastic? Why?? APPLICATION Applying Economic Concepts B. Is the elasticity of a farmer’s crop of sweet corn greater at the beginning of the growing season or in the middle of the growing season? Why? 156 Chapter 5 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Use each of the following three terms in a sentence that gives an example of the term as it relates to supply: a. elastic b. inelastic c. elasticity of supply 2. How is elasticity of supply similar to elasticity of demand? How is it different? 3. Is the supply of genuine antique furniture elastic or inelastic? Why? 4. What is the difference between industries that have elastic supply and those that have inelastic supply? 5. What is the main factor that affects elasticity of supply and how does it affect elasticity? 6. Using Your Notes How is time related to elasticity of supply? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Elasticity of Supply. Analyzing Causes Between 1997 and 2002, many gold producers cut their budgets for exploring for new sources in order to stay profitable when the price of gold was less than $350 per ounce. When the price rose above $400 per ounce in 2004, gold producers were not able to respond quickly to the increase. Use what you know about elasticity of supply to explain this causeand-effect relationship. 8. Analyzing Data In May,
Montclair Electronics sold 100 portable DVD players at $150 each. High consumer demand at the start of the summer travel season increased the price to $180. In June, the store sold 115 DVD players at the higher price. Is the supply of DVD players elastic or inelastic? Show your math calculations to support your answer. 9. Applying Economic Concepts Analyze the factors that determine elasticity of supply to explain why it is difficult for orange growers to respond quickly to changes in the price of orange juice. 10. Challenge Prices are up 8 percent at the local juice shop. Its raw materials are inexpensive and easy to find, and the labor is unskilled. Should the shop be able to raise quantity supplied more than 8 percent? Why? Calculating Elasticity The growing market for bottled yogurt smoothies is shown in the supply schedule below. Use the information in the table to determine whether the quantity supplied is growing proportionately more than increases in price. Would you expect supply for yogurt smoothies to be elastic or inelastic over a period of six months? Price ($) Quantity Supplied of Smoothies 2.00 1.75 1.50 1.25 600 450 300 200 Create a Supply Curve Use the information in the supply schedule to create a supply curve for yogurt smoothies. What does the slope of this curve indicate about elasticity of supply for yogurt smoothies? Challenge Adapt the information in the Math Challenge on page 121 to calculate the elasticity of supply using the data in the supply schedule above. Substitute quantity supplied for quantity demanded in the formula. Use ClassZone.com to complete this activity. @ Supply 157 Case Study Find an update on this Case Study at ClassZone.com Robots—Technology Increases Supply Background The increasing sophistication of technology continues to have a profound impact on the production and supply of manufactured goods. Robots— machines that can be programmed to perform a variety of tasks—are a prime example of technology’s effect on industry. Today, industrial robots perform a wide variety of functions. Although robots do everything from packaging pharmaceuticals to dispensing genetic material in biotechnical laboratories, half of all industrial robots are used to make automobiles. Robots are ideal for lifting heavy objects and for performing repetitive activities that humans find boring. Lately, though, robots are being used more for tasks that require refined skills. What’s the issue? How does technology increase supply? Study these sources to discover how robots can increase productivity. A. Online Article Japan’s low birthrate is likely to result in
via a conveyor. A simple optical positioning system ensures that the cakes are presented to the robot in a consistent position. A CAD [computer-aided design] file of the decoration shape is downloaded to the robot. Because individual cake heights may vary, a laser range finder tells the robot the height of each cake as it enters the work cell. The robot moves over the top of the cake and writes the decorative inscription.... Benefits: Ability to boost production during peak seasonal demand periods; consistently high product quality due to reduced variability on decorations; reduced... training costs. Source: www.robots.epson.com Thinking Economically In this report, how does the use of robots help the supplier respond to a seasonal change in demand? Would this robotic solution help a department store facing a holiday staffing shortage? Why or why not? THINKING ECONOMICALLY Synthesizing 1. Which of the six factors that can cause a change in supply is highlighted in the three documents? Does this factor generally increase or decrease supply? 2. Which document, B or C, addresses the issue of elasticity? Explain. 3. In which article, A or C, are the robots an example of variable costs? Why? Supply 159 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. break-even point change in quantity supplied change in supply diminishing returns elasticity of supply fixed cost increasing returns input costs law of supply marginal cost marginal product marginal revenue productivity profit-maximizing output supply supply curve supply schedule total product total revenue variable cost 1 is the quantity of a product that producers are willing and able to offer for sale. According to the 2, when price increases, quantity supplied increases, and when price decreases, quantity supplied decreases. Quantity supplied can be displayed on a chart called a 3 or on a graph called a 4. 5 is the change in 6 caused by hiring one additional worker. When marginal product begins to decrease, production is in the stage of 7. Total cost is the sum of 8 and variable costs. 9 is the additional cost of producing one more unit. When marginal cost equals 10, a company has reached 11. A 12 occurs when producers are willing to sell different amounts of a product at every price
. The six factors that change supply are input costs, 13, technology, government action, producer expectations, and number of producers. The term 14 describes how responsive producers are to price changes. It is measured by comparing 15 to change in price. CHAPTER 5 Assessment What Is Supply? (pp. 130–137) 1. What two requirements of supply must someone meet to be considered a producer? 2. What does it mean to say that quantity supplied and price have a direct relationship? What Are the Costs of Production? (pp. 138–145) 3. How does marginal product change during the three stages of production? 4. What is the relationship of total costs to profit? What Factors Affect Supply? (pp. 146–153) 5. What is the difference between change in quantity supplied and change in supply? 6. How do input costs affect supply? What Is Elasticity of Supply? (pp. 154–159) 7. How are elastic and inelastic supply different? 8. How might you calculate elasticity of supply? A P P LY Look at the graph below showing price changes for two commodities: crude oil and gasoline. 9. How is the price of gasoline related to the price of crude oil? 10. What factor that affects the supply of gasoline is shown in this graph? How does this factor affect the supply of gasoline? FIGURE 5.17 U. S. PRICES OF CRUDE OIL AND GASOLINE GASOLINE CRUDE OIL 2.50 2.00 1.50 1.00.50 160 Chapter 5 2001 2002 2003 Year 2004 2005 Source: Energy Information Administration, June 2006 11. Analyzing Data Suppose that you own a factory producing backpacks that sell for $20 each. Use the information in this table to calculate marginal cost, total revenue, and profit at each level of output. Identify the break-even point and profit-maximizing output. BAC K PAC K PRODUC T I O N COST S Production Costs How Much Are You Willing to Supply? Choose a partner. Imagine that the two of you run a software company. Your best-selling product is a program that helps businesses manage their inventory. Next year you will produce 20,000 units. The following partial supply schedule shows the prices at which you will likely sell your product during that period. Total Product Total Cost ($) SOF T WA RE SU PPLY SCHEDULE 100 200 300 400 500 600 700 800 900 3,500
5,300 7,000 8,000 8,800 9,800 11,800 14,300 17,000 12. Analyzing Effects A city puts a new rule into effect about the kinds of beverages that may be sold in schools. Sugary sodas must be replaced by bottled water, fruit juices, and sports drinks. How will this decision affect the supply of each category of beverage at the schools? What factor that affects supply is demonstrated in this situation? 13. Drawing Conclusions Both demand and supply for gasoline are inelastic. Would the elasticity of supply and demand be the same for sports cars? Why or why not? 14. Challenge When a string of hurricanes hit Florida, preparation for and cleanup from the storms increased demand for plywood. Yet prices rose only slightly, partly because large chains shipped plywood from stores around the country in anticipation of the increased demand. How does this story illustrate the law of supply and elasticity of supply? Price ($) Quantity Supplied 70 65 60 55 50 7,500 1,000 Step 1 Copy the schedule onto a sheet of paper and fill in the missing amounts in the Quantity Supplied column. Be sure that the amounts you choose adhere to the law of supply. Step 2 Draw a supply curve to illustrate your schedule. Be sure to label each axis of your curve. Step 3 Get together with three other groups. These are your competitors. Bring all of your individual supply schedules together to make a market supply schedule. Then convert the market supply schedule into a market supply curve. Step 4 You and your competitors find out that several other companies are getting ready to introduce similar inventory-control software. On your market supply curve, show how this development causes a shift in supply. Step 5 Although writing your program was difficult, now that it is written, it is relatively quick and easy to produce copies for sale. Is the supply of your product elastic or inelastic? Why? Use to complete this activity. @ ClassZone.com Supply 161 How are prices set? Prices greatly influence consumers’ buying decisions. A reduced price on this sweater may act as an incentive for these young women to make a purchase. 162 CHAPTER 6 Demand, Supply, and Prices SECTION 1 Seeking Equilibrium: Demand and Supply SECTION 2 Prices as Signals and Incentives SECTION 3 Intervention in the Price System CASE STUDY Prices for Concert Tickets Demand is the willingness to buy a good or a service and the ability to pay for it. Supply is the willingness and ability to produce and sell a product The
equilibrium price is the price at which quantity demanded and quantity supplied are the same AT T E R S You’ve been looking for a vintage concert T-shirt to buy. You see the shirt you want offered on an Internet site, but the price is too high. After exchanging several e-mails, you and the seller set a price. It’s higher than you wanted to pay and lower than the seller wanted to receive, but it’s acceptable to you both. In a market economy, the forces of demand and supply act in much the same way. They work together to set a price that buyers and sellers find acceptable. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on ticketing companies’ pricing practices. (See Case Study, pp. 186–187.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. Why have some rock bands questioned the pricing practices of certain ticketing companies? See the Case Study on pages 186–187. Demand, Supply, and Prices 163 S E C T I O N 1 Seeking Equilibrium: Demand and Supply TA K I N G N O T E S market equilibrium, p. 164 equilibrium price, p. 164 surplus, p. 167 shortage, p. 167 disequilibrium, p. 169 In Section 1, you will • explore market equilibrium and see how it is reached • explain how demand and supply interact to determine equilibrium price • analyze what causes surplus, shortage, and disequilibrium • identify how changes to demand and supply affect the equilibrium price As you read Section 1, complete a cluster diagram like the one shown using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com market equilibrium Equilibrium disequilibrium The Interaction of Demand and Supply KEY CONCEPT S In Chapters 4 and 5, you learned about how demand and supply work in the market. Recall that a market is any place or situation in which people buy and sell goods and services. Since the market is the place where buyers and sellers come together, it is also the place where demand and supply interact. As buyers and sellers interact, the market moves toward market equilibrium, a situation in which the quantity demanded of a good or service at a particular price is equal to the quantity supplied at that price. Equilibrium price is the price at which the quantity of a product demanded
by consumers and the quantity supplied by producers are equal. EXAMPLE Market Demand and Supply Schedule QUICK REFERENCE Market equilibrium occurs when the quantity demanded and the quantity supplied at a particular price are equal. Equilibrium price is the price at which the quantity demanded and the quantity supplied are equal. Let’s look at an example of how this concept works in a particular market. Karen runs a sandwich shop near an office park. Recently, she decided to offer a new product at lunchtime—prepared salads. On the first day, she makes up 40 salads and offers them at $10 each. She is disappointed when she sells only 10 and has to throw the rest away. The next day she is more cautious. She lowers 164 Chapter 6 the price to $4 each and makes only 15 salads. She discovers that 35 customers wanted her salads at the lower price. How can Karen find the right price? Over the course of a week, Karen experiments with different combinations of price and quantity of salads supplied until she discovers market equilibrium at $6 per salad. At that price, she is willing to offer 25 salads for sale, and she sells all of them. When she has either too many or too few salads, she is motivated to change her price. Market equilibrium is the point at which quantity demanded and quantity supplied are in balance. FIGURE 6.1 K A REN’S MA RKE T DEMAND AND SU PPLY SCHEDULE Price per Salad ($) Quantity Demanded Quantity Supplied 10 8 6 4 2 10 15 25 35 40 a b c 40 35 25 15 10 a At prices above $6, quantity supplied exceeds quantity demanded. b At the price of $6, the quantity demanded and the quantity supplied are equal. c At prices below $6, the quantity demanded exceeds the quantity supplied. Only at the equilibrium price of $6 are the quantity demanded and the quantity supplied equal. ANALYZE TABLES 1. What is the difference between quantity supplied and quantity demanded when the price is $10? What is the difference when the price is $2? 2. How does this market demand and supply schedule illustrate the laws of demand and supply? Use an interactive market demand and supply schedule and curve at ClassZone.com Look at Figure 6.1 to see the information that Karen gathered from her first week selling prepared salads. This table is a combined market demand and supply schedule that shows the quantities of salads supplied and demanded at various prices. Notice that quantity demanded and quantity supplied are
different at every line of the schedule except one. That line represents market equilibrium and shows the equilibrium price of $6. When Karen offers salads at prices above $6, she produces more salads than she can sell and has to throw some away. When she offers salads at prices below $6, there is unmet demand because people want more salads than Karen is willing to offer at those prices. Karen’s experience shows how the laws of demand and supply interact in the market. She wants to offer more salads at higher prices than at lower prices because she wants to earn more profit. Her costs would make it impossible to earn much, if any, profit if she were to sell the number of salads that the office workers would like to buy at the lower prices. In a similar way, while the office workers may like the idea of fresh salads for lunch, they are not willing to buy the quantity of salads that Karen wants to sell at higher prices. Find an update on market equilibrium at ClassZone.com Demand, Supply, and Prices 165 EXAMPLE Market Demand and Supply Curve Just as it is possible to convert a market demand schedule to a market demand curve or a market supply schedule to a market supply curve, it is possible to graph a combined market demand and supply schedule. Figure 6.2 portrays Karen’s market demand and supply schedule on a combined graph. On the graph, the vertical axis shows the various prices at which salads are offered for sale and bought. The horizontal axis shows the quantity of salads, whether it is the quantity demanded or the quantity supplied. The demand curve (D) is plotted using the prices and the quantities demanded (Figure 6.1, columns 1 and 2). The supply curve (S) is plotted using the prices and the quantities supplied from the combined schedule (Figure 6.1, columns 1 and 3). You can read each individual curve the same way that you did in Chapters 4 and 5, when demand and supply were shown on separate graphs. Each point on the demand curve shows the intersection of price and quantity demanded. Each point on the supply curve shows the intersection of price and quantity supplied. FIGURE 6.2 MARKET DEMAND AND SUPPLY CURVES ) 10 8 6 4 2 0 S Price per Salad ($) 10 8 6 4 2 Quantity Demanded 10 15 25 35 40 Quantity Supplied 40 35 25 15 10 c b a D 10 20 30 40 50 Quantity of salads a The demand curve (D) shows quantity demanded at various prices and slopes down.
b The supply curve (S) shows quantity supplied at various prices and slopes up. c This is the point of market equilibrium, where quantity supplied and demanded are equal. ANALYZE GRAPHS 1. What is the quantity supplied at $8? What is the quantity demanded at $8? 2. How do these market demand and supply curves illustrate the concept of equilibrium price? Look at Figure 6.2 again and notice that the two curves intersect at only one point; this is the point of market equilibrium. It occurs when quantity demanded and quantity supplied are the same—25 salads at $6. Showing the two curves together allows you to see the interaction of demand and supply graphically. APPLICATION Applying Economic Concepts A. Create a combined market demand and supply schedule for pizza at prices of $25, $20, $15, $10, and $5, where $10 is the price at which there is equilibrium. 166 Chapter 6 Reaching the Equilibrium Price KEY C ONCEPT S It’s clear from the example of Karen’s salads that markets don’t arrive at equilibrium price instantly; they often require a process of trial and error. The market may experience a surplus, which is the result of quantity supplied being greater than quantity demanded, usually because prices are too high. Or a shortage may occur, the result of quantity demanded being greater than quantity supplied, usually because prices are too low. E XAMPLE Surplus, Shortage, and Equilibrium In Figure 6.3, we can see how Karen’s experience demonstrates the concepts of surplus and shortage. It also shows that equilibrium occurs when there is neither a surplus nor a shortage, because quantity demanded and quantity supplied are equal. QUICK REFERENCE Surplus is the result of quantity supplied being greater than quantity demanded. Shortage is the result of quantity demanded being greater than quantity supplied. FIGURE 6.3 SURPLUS, SHORTAGE, AND EQUILIBRIUM ) 10 10 20 30 40 50 Quantity of salads a When the price is above $6, quantity supplied exceeds quantity demanded, and there is a surplus (shaded in orange). b When the price is below $6, quantity demanded exceeds quantity supplied, and there is a shortage (shaded in blue). c At the equilibrium price, there is neither a surplus nor a shortage. ANALYZE GRAPHS 1. Is there a surplus or a shortage when the price is $10? How big is that surplus or
shortage? How great is the surplus or shortage when the price is $2? 2. What does this graph illustrate about surplus, shortage, and equilibrium price? In Figure 6.3, there is a surplus in the area shaded orange. As Karen discovered when she tried to sell salads at prices above $6, she had too many and had to throw some away. The amount of surplus is measured by the horizontal distance between the two curves at each price. For example, at the price of $8, the distance shown by the black line between 15 and 35 shows a surplus of 20 salads. When there is a surplus, prices tend to fall until the surplus is sold and equilibrium is reached. Producers might also choose to cut back their production to a quantity that is more in line with what consumers demand at the higher prices. Demand, Supply, and Prices 167 The blue area in Figure 6.3 represents where there is a shortage. When Karen decided to charge less than $6, she had too few salads and lots of unhappy customers who weren’t able to get the salads they wanted. As with the surplus, the amount of shortage is measured by the horizontal distance between the two curves at each price. For example, at the price of $4, the distance shown by the black line between 15 and 35 salads shows a shortage of 20 salads. When there is a shortage, producers raise prices in an attempt to balance quantity supplied and quantity demanded. Producers may also try to increase quantity supplied to meet the quantities demanded at the lower prices. EXAMPLE Holiday Toys The concepts of surplus and shortage and the move to equilibrium are active in many markets at different times. Perhaps they are most visible in the market for toys during the holiday shopping season. Toys are often fads, and children’s tastes change rapidly. It is difficult for marketers to know how much to supply and at what price to best meet the quantities demanded by consumers. Sometimes they overestimate a toy’s popularity and end up with a surplus. If they underestimate popularity, they are faced with a shortage. In 1996, for example, Tyco Toys Inc. introduced Tickle Me Elmo. The toy included a microchip that made the toy laugh when it was touched. Tyco expected the toy to be popular and ordered about 500,000 for the holiday season. It was priced around $30. Sales started slowly, and stores thought they might have a surplus. But after several popular television personalities promoted it, Tickle Me Elmo became
the hottest toy of that holiday season, and a shortage developed. Even when prices increased markedly, buyers were undeterred. They continued to purchase the toys until they were all gone. Tyco tried to increase its supply, but the factories that made Tickle Me Elmo were located in Asia, and the shortage persisted throughout the holiday season. By spring, the quantity supplied had doubled. By then, however, the height of the fad was over. Initially, stores tried to sell the toys at the same high prices charged during the holiday season. But consumers were reluctant to buy, and a surplus resulted. Eventually, the market reached equilibrium at a price of about $25. When you see suppliers reducing prices, it is often because they have a surplus of products to sell. Consider, for example, what happens to the prices of clothing items that are out of season or no longer in fashion. On the other hand, if an item becomes particularly popular or is in short supply for some other reason, suppliers will raise prices. The market does not always reach equilibrium quickly, but it is always moving toward equilibrium. APPLICATION Applying Economic Concepts B. Look back at the market demand and supply schedule you created for Application A on p. 166. Use it to create a graph showing the interaction of demand and supply and mark it to show surplus, shortage, and equilibrium. Holiday Shortages Consumer tastes often cause spikes in demand for certain items during the holidays. Create a demand and supply curve at ClassZone.com 168 Chapter 6 Equilibrium Price in Real Life KEY C ONCEPT S In theory, the relationship between demand and supply in the market seems straightforward. The real world, however, is more complex. In earlier chapters, you learned that there are several factors that can cause demand and supply to change. When there is an imbalance between quantity demanded and quantity supplied, a state of disequilibrium exists, and the process of finding equilibrium starts over again. E XAMPLE Change in Demand and Equilibrium Price Let’s take a look at how the market moves from disequilibrium by considering the effect of changes in demand on the equilibrium price for athletic shoes. Recall that a change in demand occurs when one of six factors—income, consumer taste, consumer expectations, market size, substitutes, and complements—prompts consumers to change the quantity demanded at every price. In Figures 6.4 and 6.5, the intersection of the demand curve (D1) and the supply curves (S) shows an equilibrium price of
in Figure 6.4. Notice that this new demand curve (D2) intersects the supply curve at a lower price, around $65. This becomes the new equilibrium price. At this QUICK REFERENCE Disequilibrium occurs when quantity demanded and quantity supplied are not in balance. FIGURES 6.4 AND 6.5 CHANGES IN DEMAND AND EQUILIBRIUM PRICE FIGURE 6.4 DECREASE IN DEMAND FIGURE 6.5 INCREASE IN DEMAND ) 125 100 75 50 25 0 S a c D2 D1 125 100 75 50 25 0 S d b D1 D3 1 2 3 4 5 6 7 Quantity of shoes (in thousands) Quantity of shoes (in thousands) ANALYZE GRAPHS 1. What happens to quantity demanded at $100 when demand decreases? What happens to quantity demanded at $100 when demand increases? 2. Does change in demand have a direct or inverse relationship to equilibrium price? Explain your answer. Use an interactive market demand and supply curve to see changes in demand, supply, and equilibrium price at ClassZone.com a In Figure 6.4, de- mand decreases; the demand curve shifts left and intersects the supply curve at a lower point. b In Figure 6.5, de- mand increases; the demand curve shifts right and intersects the supply curve at a higher point. c When demand decreases (Fig. 6.4), the equilibrium price falls to about $65. d When demand increases (Fig. 6.5), the equilibrium price rises to about $90. Demand, Supply, and Prices 169 new, lower equilibrium price, the quantity demanded decreases to 2,500 pairs of shoes. In other words, when consumers demand fewer goods and services at every price, the equilibrium price will fall and suppliers will sell fewer units—even though the price is lower. Suppose that an increase in the number of young adults causes demand for athletic shoes to increase. When there is an increase in demand, the demand curve shifts to the right, as shown in Figure 6.5. Notice that the new demand curve (D3) intersects the supply curve at a higher price, around $90. As the equilibrium price increases to this higher level, the quantity demanded also increases to 3,500 pairs of shoes. When consumers demand more goods and services at every price, equilibrium price will rise and suppliers will sell more, even at higher prices. EXAMPLE Change in Supply and Equilibrium Price Now let
’s consider how changes in supply might affect equilibrium price. Recall that a change in supply occurs when something in the market prompts producers to offer different amounts for sale at every price. Remember from Chapter 5 that the six factors that can change supply are input costs, productivity, technology, government action, producer expectations, and number of producers. In Figures 6.6 and 6.7, the intersection of the supply curve (S1) and the demand curve (D) shows an equilibrium price of $75, with quantity supplied and demanded of 3,000 pairs of shoes. If the price of the raw materials needed to produce athletic shoes increases, the result is a decrease in supply of these shoes at every price. FIGURES 6.6 AND 6.7 CHANGES IN SUPPLY AND EQUILIBRIUM PRICE FIGURE 6.6 DECREASE IN SUPPLY FIGURE 6.7 INCREASE IN SUPPLY ) 125 100 75 50 25 0 S2 S1 125 100 75 50 25 0 S1 S3 Quantity of shoes (in thousands) Quantity of shoes (in thousands) ANALYZE GRAPHS 1. What happens to quantity supplied at $100 when supply decreases? What happens to quantity supplied at $100 when supply increases? 2. How do these graphs illustrate the relationship between change in supply and change in equilibrium price? a In Figure 6.6, supply decreases; the supply curve shifts left and intersects the demand curve at a higher point. b In Figure 6.7, supply increases; the supply curve shifts right and intersects the demand curve at a lower point. c When supply decreases (Fig. 6.6) the equilibrium price rises to about $90. d When supply increases (Fig. 6.7) the equilibrium price falls to about $55. 170 Chapter 6 In this situation, the supply curve shifts to the left, as shown in Figure 6.6. Notice that the new supply curve (S2) intersects the demand curve at a higher price, around $90. This is the new equilibrium price. Because of this increase in price, the quantity demanded at equilibrium decreases to 2,500 pairs of shoes. In other words, when there are fewer goods and services available at every price, equilibrium price will rise. When new technology allows the manufacturer to produce shoes more efficiently, supply increases, and the supply curve shifts to the right, as shown in Figure 6.7. Notice that the new supply curve (S3) intersects
the demand curve at a lower price, about $55. This is the new equilibrium price. Because of this decrease in price, the quantity demanded at equilibrium increases to about 4,100 pairs of shoes. In other words, when there are more goods and services available at every price, equilibrium price will fall. Technology Both supply and equilibrium price are affected when technology improves the manufacturing process. Look at Figures 6.4, 6.5, 6.6, and 6.7 once more and notice which situations cause equilibrium price to fall and which cause equilibrium price to rise. The relationships between changes in demand or supply and changes in equilibrium price are illustrated in Figure 6.8. Equilibrium price falls when there is a decrease in demand or an increase in supply. Equilibrium price rises when there is an increase in demand or a decrease in supply. In other words, when consumers want less or producers supply more, prices will fall. When consumers want more or producers supply less, prices will rise. FIGURE 6.8 EQUILIBRIUM PRICE AND CHANGES IN DEMAND AND SUPPLY If demand decreases supply increases OR THEN equilibrium price falls. If demand increases supply decreases OR THEN equilibrium price rises. AP P LI CATION Analyzing Effects C. If one of the three pizza parlors in your neighborhood closes, what will happen to the supply of pizza? How will that affect the equilibrium price of pizza? Demand, Supply, and Prices 171 For more on interpreting graphs, see the Skillbuilder Handbook, page R29. Interpreting Graphs: Shifting Curves Graphs show statistical information in a visual manner. A graph that shows a shifting curve should immediately alert the reader to one of the following: a change in quantity demanded at every price, or a change in quantity supplied at every price. In Figure 6.9, a change in the number of producers has caused an increase in supply at every price. The sandwich shop across the street from Forest View High School now has a competitor. TECHNIQUES FOR ANALYZING SHIFTING CURVES Use the following strategies, along with what you learned throughout Section 1, to analyze the graph. Use the title to identify the main idea of the graph. If supply has shifted, then we know that quantity supplied at every price has either increased or decreased. Read the axis labels carefully. When both quantity supplied and demanded are present, look for an intersection to find equilibrium price. FIGURE 6.9 SHIFT IN SUPPLY OF
SANDWICHES ) S1 S2 b c D 20 40 60 80 100 120 Quantity of sandwiches demanded and supplied Use the annotations to find key elements of the graph. Annotation a shows the equilibrium price where curve S1 meets curve D. a This is the initial equilibrium price. b Curve shifts to the right. c This is the new equilibrium price. Notice that b shows a shift to the right. An increase in supply always shows a rightward shift; a decrease in supply always causes a leftward shift. Notice the new equilibrium price, c. An increase in supply results in a lower equilibrium price. T HINKING ECONOMICALLY Analyzing 1. What are the pre-shift and post-shift equilibrium prices for a sandwich? Will an increase in quantity supplied at every price always result in a lower equilibrium price? Why? 2. Imagine that instead of an increase in supply, there is a decrease in demand. How will the equilibrium price change? Why? 3. On a separate sheet of paper, sketch intersecting quantity supplied and demanded curves with an equilibrium price of $4 at 80 sandwiches. How have the curves shifted from those that appear in Figure 6.9? 172 Chapter 6 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. market equilibrium disequilibrium b. surplus shortage 2. How are surplus and shortage related to equilibrium price? 3. Why is equilibrium price represented by the intersection of the supply and demand curves in a particular market? 4. Why do changes in demand or supply cause disequilibrium? 5. Why is the market always moving toward equilibrium? 6. Using Your Notes How is equilibrium price related to market equilibrium? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com market equilibrium Equilibrium disequilibrium. Analyzing Data Look at Figures 6.4, 6.5, 6.6, and 6.7 again. What happens to surplus and shortage as equilibrium price changes in each graph? What general conclusions can you draw from this information? 8. Analyzing Causes Suppose that the federal government decides to increase the excise tax on cellular phone services by 0.1 percent. Why will this action cause the equilibrium price of cellular phone services to rise? 9. Applying Economic Concepts Between 2003 and 2005, there was huge growth in the market for premium blue jeans priced at $200 or more per pair. The growth
was largely fueled by popular magazines showing celebrities wearing certain brands. Then, in the summer of 2005, major department stores started cutting prices on the jeans; they were also found on Web sites that offer jeans at discount prices. Use the economic concepts that you learned in this section to describe what is happening in this market. 10. Challenge Study Figures 6.4, 6.5, 6.6, and 6.7 again. What would happen if a change in consumer taste caused an increase in demand for athletic shoes and more suppliers entered the market at the same time? Assume that the increases in demand and in supply are proportionately the same. How would this result be different if each of these changes happened separately? Finding Equilibrium Price Suppose that you are a manufacturer of a new mini refrigerator for college dorm rooms. You expect your product to be popular because of its compact size and high tech design. After a few weeks in the market you are able to develop the following market demand and supply schedule. Price per Refrigerator ($) Quantity Demanded Quantity Supplied 225 200 175 150 125 500 1,000 1,500 2,500 4,000 6,000 4,500 3,500 2,500 1,500 Create a Demand and Supply Curve Use this market demand and supply schedule to create a market demand and supply curve and determine the equilibrium price. Challenge Calculate surplus or shortage at every price and suggest ways the manufacturer could try to eliminate the surplus and raise the equilibrium price. Demand, Supply, and Prices 173 S E C T I O N 2 Prices as Signals and Incentives TA K I N G N O T E S In Section 2, you will competitive pricing, p. 174 • analyze how the price system incentive, p. 176 works • explain how prices provide information about markets • describe how prices act as incentives to producers As you read Section 2, complete a chart like the one shown to keep track of how each key concept affects producers and consumers. Use the Graphic Organizer at Interactive Review @ ClassZone.com Producers Consumers Competitive pricing Incentive How the Price System Works KEY CONCEPT S To better understand how price works in the market, let’s look at how one kind of change in supply affects the equilibrium price. More producers in a market increases supply, which leads to increased competition and a lower equilibrium price. Competitive pricing occurs when producers sell goods and services at prices that best balance the twin desires of making the highest profit and luring customers away from rival producers. By entering
a market at a lower price, a new supplier can add to its customer base while it maintains overall profits by selling more units. EXAMPLE Competitive Pricing Let’s look at an example of competitive pricing. As winter approaches, Elm Street Hardware prices its snow shovels at $20. But Uptown Automotive sees an opportunity to take some customers (mostly for tools, which both stores sell) from Elm Street. Uptown enters the snow shovel market, raising the overall supply. It also prices the shovels at $13. Uptown has a lower profit margin per shovel, but hopes to sell hundreds of them in order to maintain overall profit. Elm Street can choose to lower its prices as well or risk losing customers. QUICK REFERENCE Competitive pricing occurs when producers sell products at lower prices to lure customers away from rival producers, while still making a profit. 174 Chapter 6 E XAMPLE Characteristics of the Price System In a market economy, the price system has four characteristics. 1. It is neutral. Prices do not favor either the producer or consumer because both make choices that help to determine the equilibrium price. The free interactions of consumers (who favor lower prices) and producers (who favor higher prices) determines the equilibrium price in the market. 2. It is market driven. Market forces, not central planning, determine prices, so the system has no oversight or administration costs. In other words, the price system runs itself. 3. It is flexible. When market conditions change, prices are able to change quickly in response. Surpluses and shortages motivate producers to change prices to reach equilibrium. 4. It is efficient. Prices will adjust until the maximum number of goods and services are sold. Producers choose to use their resources to produce certain goods and services based on the profit they can make by doing so10 Characteristics of the Price System in a Market Economy Neutral Both the producer and the consumer make choices that determine the equilibrium price. Efficient Resources are allocated efficiently since prices adjust until the maximum number of goods and services are sold. Market Driven Market forces, not government policy, determine prices. In effect, the system runs itself. Flexible When market conditions change, so do prices Are the Characteristics of the Price System? What ANALYZE CHARTS Choose two of the characteristics of the price system shown in the chart and explain how each is illustrated through the example of competitive pricing. AP P LI CATION Analyzing and Interpreting Data A. If Karen sold 25 salads at
$6 each, how many would she need to sell at $5.50 to make at least the same amount of total revenue? Demand, Supply, and Prices 175 Prices Motivate Producers and Consumers KEY CONCEPT S QUICK REFERENCE An incentive encourages people to act in certain ways. The laws of demand and supply show that consumers and producers have different attitudes toward price. Consumers want to buy at low prices; producers want to sell at high prices. Therefore, prices motivate consumers and producers in different ways. You learned in Chapter 1 that an incentive is a way to encourage people to take a certain action. Here, you’ll learn that in the price system, incentives encourage producers and consumers to act in certain ways consistent with their best interests. EXAMPLE Prices and Producers For producers, the price system has two great advantages: it provides both information and motivation. Prices provide information by acting as signals to producers about whether it is a good time to enter or leave a particular market. Rising prices and the expectation of profits motivate producers to enter a market. Falling prices and the possibility of losses motivate them to leave a market. A shortage in a market is a signal that consumer demand is not being met by existing suppliers. Recall that a shortage often occurs because prices are too low relative to the quantities demanded by consumers. Producers will view the shortage as a signal that there is an opportunity to raise prices. Higher prices act as an incentive for producers to enter a market. In other words, the prospect of selling goods at higher prices encourages producers to offer products for that market. As more producers are motivated by high prices to enter a market, quantity supplied increases. When prices are too high relative to consumer demand, a surplus occurs. Producers can respond to a surplus either by reducing prices, or by reducing production to bring it in line with the quantity demanded at a particular price. Either way, falling prices signal that it is a good time for producers to leave the market. Sometimes, less efficient producers leave a market completely, as increased competition and lower prices drive them out of business. More often, producers shift their business to focus on opportunities in markets with higher potential profits. FIGURE 6.11 CD PRICES AND PRODUCERS 1. Competition from DVDs and video games causes a slump in CD sales–a surplus in CDs. 3. Discount chains begin to sell CDs, often below cost, to attract customers; competitive pricing of CDs. CD prices decrease CD prices increase CD prices decrease 2. Some CD makers switch
production to DVDs, video games; fewer CDs are produced–a shortage of CDs. 4. Many small record stores go out of business or devote less shelf space to CDs, more to DVDs and video games. 176 Chapter 6 Competitive pricing in the market often informs the choices made by producers. When a market is growing, and when there is unmet demand, a producer may decide to enter the market with a price that is lower than its competitor’s. The new producer can still, however, earn a profit by selling more units at the lower price. So, while prices are the signals that are visible in the market, it is the expectation of profits or the possibility of losses that motivates producers to enter or leave a market. E XAMPLE Prices and Consumers Prices also act as signals and incentives for consumers. Surpluses that lead to lower prices tell consumers that it is a good time to buy a particular good or service. Producers often send this signal to consumers through advertising and store displays that draw consumers to certain products. Producers may also suggest that the low prices won’t last, encouraging consumers to buy sooner rather than later. High prices generally discourage consumers from buying a particular product and may signal that it is time for them to switch to a substitute that is available at a lower price. A high price may signal that a particular product is in short supply or has a higher status. Brand marketers rely on the consumer perception that a certain logo is worth a higher price. Recall what you learned about normal and inferior goods in Chapter 4. Most consumers prefer to buy normal goods at the best possible price. They will buy inferior goods only when they cannot afford something better. While price is a powerful incentive to consumers, the other factors that affect demand also influence consumers’ buying habits. YO U R EC PRIC ES AND CONSU M E RS How Does Price Affect Your Decision? A new digital video camera with state-of-the-art features costs $500, but you’ve saved only $250. You can either buy a less expensive substitute with the money you have now, or you can save up to buy the advanced camera later. If other consumers also choose to wait to buy the new camera, a surplus may develop, and the price may decrease.? ▲ Buy now ▲ Save for later AP P LI CATION Making Inferences B. A cup of gourmet coffee commands a higher price than a regular coffee. How will this fact influence the take-out coffee market?
Demand, Supply, and Prices 177 ECO N O M I C S PAC ES E T T E R Michael Dell: Using Price to Beat the Competition High-tech entrepreneur Michael Dell saw an opportunity to use competitive pricing to take business away from much larger companies. By 2005, IBM Corporation, Compaq Computer Corporation, and others had either left the PC market or were facing major problems. How did Dell thrive as its competitors struggled? Lowering Costs to Reduce Prices Michael Dell began assembling and selling computers as a freshman in college. He became so successful that he quit college in 1984 to focus on his business. He had sales worth $6 million in his first year. Dell’s success was largely due to his approach to marketing and production. He bypassed computer retailers and sold over the telephone directly to knowledgeable computer users in business and government. Each computer was built to customer requirements and assembled after it was ordered. In this way, Dell lowered his costs significantly and became the low-price leader in the market. The company’s sales grew from $69.5 million in 1986 to almost $258 million in 1989. Dell was also a pioneer in recognizing In Dell's TechKnow program, students learn to assemble and upgrade a computer, which they can then keep. the potential for sales via the Internet. This strategy allowed the company to maintain close contact with its customers and to adjust its prices frequently, up and down, as market conditions dictated. Competitors who sold only in retail stores found it hard to compete on price because their costs were much higher. By 2005, Dell was the world’s leading supplier of PCs, with annual sales of almost $50 billion. Now Dell is using his experience to make waves in the consumer electronics (flat-panel TVs, MP3 players, and the like) market. He sees the line between these two markets eventually fading. “The whole new ballgame is these worlds [computing and consumer electronics] converging,” Dell believes, “and that’s a world we’re comfortable in.” APPLICATION Drawing Conclusions C. What incentive did Michael Dell have to sell computers at lower prices than his competitors? FAST FACTS Michael S. Dell Title: Chairman of Dell Inc. Born: February 23, 1965, Houston, Texas Major Accomplishment: Pioneered the direct sale of personal computers to consumers Key Product Lines: Desktop PCs, notebook computers, workstation systems, servers, printers, flat-screen TVs, PDAs Honors
: Youngest CEO of a Fortune 500 company (1992), America’s Most Admired Company (2005) Personal Fortune: $16 billion (2005) Employees: 65,200 (2006) Find an update on Michael Dell at ClassZone.com 178 Chapter 6 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Use each of the two terms below in a sentence that illustrates the meaning of the term: a. competitive pricing b. incentive 2. Explain the four characteristics of the price system. 3. Why is the price system an efficient way to allocate resources? 4. How do prices serve as signals and incentives to producers to enter a particular market? to leave a certain market? 5. How does the story of Dell Inc. demonstrate the effects of competitive pricing? 6. Using Your Notes How does Producers Consumers competitive pricing affect consumers? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com Competitive pricing Incentive. Making Inferences A local supermarket decides to sell a premium brand of meats and cheeses in its deli department. This brand is priced about $2 more per pound than the store brand. About 80 percent of the space in the deli display cases is devoted to the premium brand and 20 percent to the store brand. a. How did price serve as an incentive to the supermarket? b. What kind of signals is the supermarket sending to its customers with this pricing strategy? 8. Applying Economic Concepts A candy company whose products sold in supermarkets for about $3 a bag decided to enter the growing gourmet chocolate market. It purchased two small companies that made premium chocolates that sold for much higher prices. How does this story reveal the way the price system works as an incentive for producers while allocating resources efficiently? 9. Challenge A large discount store has built its reputation on offering consumers low prices. However, its customers come from many different income levels. Recently, the store began offering higher priced jewelry and consumer electronics products. What signal might this send to producers of other premium products who have never sold in discount stores before? Using Prices as Incentives As you’ve learned in Section 2, prices motivate producers to act in certain ways. What actions do producers take in response to rising prices? How about falling prices? Identify Price Incentives Consider each situation that follows. Decide whether the scenario described is associated with rising prices or with falling prices. • A farmer switches to organic methods when a
report says organic foods are healthier. • To maintain market share, a car wash adjusts its prices to meet a competitor’s. • After a hot, dry spring, a landscaper decides to get out of the business. • A retailer decides to begin selling this holiday season’s must-have toy. Challenge Which of the above situations descibes a case of competitive pricing? What might happen to the producer if it did not take the action described? Demand, Supply, and Prices 179 S E C T I O N 3 Intervention in the Price System TA K I N G N O T E S price ceiling, p. 180 price floor, p. 182 minimum wage, p. 182 rationing, p. 183 black market, p. 183 In Section 3, you will • explain how government uses price ceilings to keep prices from rising too high • describe how government uses price floors to keep prices from going too low • discuss how government uses rationing to allocate scarce resources and goods As you read Section 3, complete a hierarchy diagram like this one to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Price Controls main idea main idea main idea details details details Imposing Price Ceilings KEY CONCEPT S QUICK REFERENCE A price ceiling is the legal maximum price that sellers may charge for a product. You’ve seen how prices adjust to changes in demand and supply as the market constantly strives for equilibrium. Sometimes, however, people think it is a good idea to interfere with the free market mechanism in order to keep the price of a good or service from going too high. An established maximum price that sellers may charge for a good or service is called a price ceiling. The price ceiling is set below the equilibrium price, so a shortage will result. EXAMPLE Football Tickets and Price Ceilings Let’s look at an example of a price ceiling in ticket prices for college football. The Trenton University Tigers are a winning team with many loyal fans. The university prints 30,000 tickets for every game and sells them for $15 each. At that price, 60,000 fans want to buy the tickets, so there is a shortage of 30,000 tickets for every game. The university could resolve the shortage by letting the price rise until quantity demanded and quantity supplied are equal. When this solution is proposed, the university president says she would rather keep the tickets affordable for students. Indeed many students get tickets for $15. On game day, however, ticket
scalpers stand outside the stadium and sell some tickets for $50 or more. 180 Chapter 6 E XAMPLE Rent Control as a Price Ceiling In the past, many cities passed rent control laws in an effort to keep housing affordable for lower-income families. These laws control when rents can be raised and by how much, no matter what is going on in the market. Of course, the people who live in rent-controlled housing appreciate the lower price in the short term. But rent control can have unexpected consequences. Without the possibility of raising rents to match the market, there is no incentive to increase the supply of rental housing, and a shortage soon develops. In addition, landlords are reluctant to increase their costs by investing money in property maintenance, so housing conditions often deteriorate. By 2005, rent control was becoming far less common as most cities realized it made housing shortages worse in the long run. Santa Monica, California, is an example of a city that had strict rent control laws. In the late 1990s, state legislators passed a law that changed the way local communities could regulate rental housing. As a result, property owners in Santa Monica could let the market determine the initial rent when a new tenant moved in, although the city’s rent control board still regulated yearly rent increases thereafter. Figure 6.12 illustrates what happened to rents when the new law fully took effect. Rents increased by 40 to 85 percent, showing that the apartments had been priced artificially low. The increases reflect the shortage that rent control had created. FIGURE 6.12 RENT CONTROL IN SANTA MONIC,000 1,800 1,600 1,400 1,200 1,000 800 600 400 0 1890 Key: Rent controlled Decontrolled 1397 b 775 a 553 1000 991 630 772 Studio 1-bedroom Types of Apartments 2-bedroom 3+-bedroom a The red bars show the median rent for each type of apartment when rent control was in effect. b The blue bars show the median rent for each type of apartment when the new law allowed the market to set the rent for new tenants. The graph shows that rent control had kept the rate lower than what the market would bear. Source: Santa Monica Rent Control Board, April 13, 1999 ANALYZE GRAPHS 1. What happened to the rent for one-bedroom apartments when the new law ended rent control? 2. Who would be more in favor of the changes that happened in the rental market in Santa Monica, landlords or tenants? Why
? AP P LI CATION Applying Economic Concepts A. Create a demand and supply graph for Trenton University football tickets showing how the price ceiling of $15 is below the equilibrium price. Demand, Supply, and Prices 181 Setting Price Floors QUICK REFERENCE A price floor is a legal minimum price that buyers must pay for a product. The minimum wage is a legal minimum amount that an employer must pay for one hour of work. Find an update on the minimum wage at ClassZone.com KEY CONCEPT S Sometimes the government decides to intervene in the price system to increase income to certain producers. A price floor is an established minimum price that buyers must pay for a good or service. For example, the government has used various programs designed to provide price floors under corn, milk, and other agricultural products. The goal of these price floors is to encourage farmers to produce an abundant supply of food. EXAMPLE Minimum Wage as a Price Floor One well-known example of a price floor is a minimum wage. A minimum wage is the minimum legal price that an employer may pay a worker for one hour of work. The United States government established its first minimum wage in 1938. The 1930s were a period of low wages, and the government hoped to increase the income of workers. If the minimum wage is set above the equilibrium price for certain jobs in a market, employers may decide that paying the higher wages is not profitable. As a result, they may choose to employ fewer workers, and unemployment will increase. If the minimum wage is set below the equilibrium price, then it will have no effect. FIGURE 6.13 M I N I MUM WAG E A S A PR I C E FLOOR This point shows the equilibrium price for a labor market. b The black dotted line shows a minimum wage set above the equilibrium price. c The blue dotted line shows a minimum wage set below the equilibrium price. The length of black dotted line that falls between the demand curve and the supply curve represents a surplus—in other words, unemployment. Quantity supplied of minimum-wage workers ANALYZE GRAPHS 1. Assume the minimum wage is set at the dotted black line. What are the costs and benefits of increasing it? 2. Is the minimum wage set at the dotted blue line an effective price floor? Why? APPLICATION Analyzing Effects B. Suppose that the Trenton University Tigers were so bad that only 10,000 people want to buy tickets for $15. What effect would keeping $15 as
a price floor have? 182 Chapter 6 Rationing Resources and Products KEY C ONCEPT S The market uses prices to allocate goods and services. Sometimes in periods of national emergency, such as in wartime, the government decides to use another way to distribute scarce products or resources. Rationing is a system in which the government allocates goods and services using factors other than price. The goods might be rationed on a first-come, first-served basis or on the basis of a lottery. Generally, a system is set up that uses coupons allowing each person a certain amount of a particular item. Or the government may decree that certain resources be used to produce certain goods. When such a system is used, some people try to skirt the rules to get the goods and services they want, creating what is known as a black market. In a black market, goods and services are illegally bought and sold in violation of price controls or rationing. QUICK REFERENCE Rationing is a government system for allocating goods and services using criteria other than price. The black market involves illegal buying or selling in violation of price controls or rationing. E XAMPLE Rationing Resources During World War II, the United States government empowered the Office of Price Administration, which was established in 1941, to ration scarce goods. The hope was that these goods would be distributed to everyone, not just those who could afford the higher market prices born of shortages. It also allocated resources in ways that favored the war effort rather than the consumer market. Figure 6.14 shows some of the goods that were rationed. Rationing also led consumers to look for substitutes. Margarine, a butter substitute, was purchased in huge quantities during the war. FIGURE 6.14 R AT IONED GOODS DU R I NG WO RLD WA R I I Food Other Goods sugar meat butter, fats, and oils most cheese chocolate coffee automobile tires gasoline fuel oil clothing, especially silk and nylon shoes Demand, Supply, and Prices 183 Rationing for All The U.S. government’s World War II rationing program affected nearly every household in the United States. Rationing in China Shortages of tofu, a staple of the Chinese diet, led to rationing in 1989. 184 Chapter 6 North Korea maintained a strict rationing system between 1946 and 2002. Most importantly, staple foods—meat, rice, and cabbage—were strictly rationed. However, the system was plagued by inefficiency and corruption. The amount of your
ration was generally determined by who you knew, where you lived, and what your occupation was. Government officials in the largest cities often received more than their allotment, while the majority of people got by with less (or received lessnutritious substitutes). Some families had meat or fish only a few times a year. Between 1996 and 2000, widespread famine in North Korea made the situation desperate. Ration coupons were still distributed, but in most cases, the rations were not. As many as a million people died due to the famine. In response, people established unofficial markets where they traded handicrafts for food. In 2002, the government officially legalized these market activities, and prices rose sharply. Wages also increased. Skeptical of markets, however, the leaders of North Korea were, in 2005, considering a return to the rationing system that failed them in the past. EXAMPLE Black Markets—An Unplanned Result of Rationing When rationing is imposed, black markets often come into existence. During World War II, black markets in meat, sugar, and gasoline developed in the United States. Some people found ways, including the use of stolen or counterfeit ration coupons, to secure more of these scarce goods. During the height of North Korea’s rationing system, free trade in grain was expressly forbidden, and most other markets were severely restricted. Prices were very high at the markets that did exist. In 1985, it cost half of the average monthly salary of a typical North Korean to buy a chicken on the black market. Even after the government began allowing some market activities in 2002, the black market flourished because many forms of private property, including homes and cars, were still illegal. Some people started smuggling clothes, televisions, and other goods from China to sell in North Korea. (You’ll read more about the black market in the discussion of the underground economy in Chapter 12.) APPLICATION Making Inferences C. How does the example of rationing during World War II show that the price system is a more efficient way to allocate resources? S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. price floor b. rationing minimum wage black market 2. What is the difference between a price floor and a price ceiling? 3. What kind of surplus might be created by the minimum wage? 4. How does the existence of the black market work against the intended purpose of rationing
? 5. Aside from turning to the black market, how do consumers make up for goods that are rationed? 6. Using Your Notes What is the usual result of a price ceiling? Refer to your completed diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Price Controls main idea main idea main idea details details details. Analyzing Causes Opponents of rent control cite comparisons of cities that regulate rents with cities that do not. Their evidence shows that there is more moderately priced housing available in cities that let the market set the rates for rent. What would account for the differences in availability? 8. Making Inferences The percentage of workers who were paid the minimum wage or less decreased from 6.5 percent in 1988 to 3 percent in 2002 to 2.7 percent in 2004. What does this trend tell you about the relationship of the minimum wage to the equilibrium wage for those kinds of work? 9. Applying Economic Concepts In the wake of sharply rising gasoline prices in the summer of 2005, several states considered putting a ceiling on the wholesale price of gasoline. What would be the likely result of such a price control? Would it be an effective strategy for lowering gas prices? 10. Challenge Many states have laws against so-called price gouging. These laws make it illegal to sell goods and services at levels significantly above established market prices following a natural disaster. What economic argument might be used against such laws? Understanding Price Floors In agriculture, price floors are known as price supports. The government sets a target price for each crop, and if the market price is below that target, it will pay farmers the difference. Suppose that you are a farmer with 400 acres planted in corn. The following graph shows the supply and demand for your crop.50 3.75 3.00 2.25 1.50 0.75 0 Target price S D 20 10 30 Bushels of corn (in thousands) 50 40 60 Calculate the Effect of the Price Support How many bushels of corn will you sell at the equilibrium price? How much revenue will you make? How many bushels do you want to sell at the target price? How many bushels are consumers willing to buy at that price? What is the difference? How much will the government have to pay you for that surplus? Challenge What changes in supply or demand would move the market equilibrium price closer to the target price? Demand, Supply, and Prices 185 Case Study Find an update on this Case Study at ClassZone.com Prices for Concert Tickets Background
Americans spend billions of dollars on concert tickets yearly—an estimated $3 billion in 2005. With ticket prices for the most popular acts averaging more than $50, most younger or less affluent fans can no longer afford to attend many live concerts. And yet, remarkably, forecasters believe that concert ticket prices have yet to peak. Ticket prices reflect a number of costs. Performers must cover expenses such as travel, costumes, instruments, and equipment before they reap a profit. Venues, or places where concerts are held, also seek to make a profit, as do ticket distributors. However, in the United States, the sale of concert tickets, along with most other goods and services, is driven by three basic elements of a market economy— demand, supply, and pricing. What’s the issue? How do demand, supply, and pricing affect the concert ticket market? Study these sources to discover the factors that affect demand and supply, and their impact on the price of concert tickets. A. Congressional Transcript Pearl Jam believed that TicketMaster Corporation, their ticket distributor, was setting too high a price on the band’s concert tickets. This statement, submitted to Congress along with oral testimony on June 30, 1994, explains Pearl Jam’s stance. Pearl Jam Tries to Place Ceiling on Ticket Prices To keep ticket prices affordable, Pearl Jam appeals to Congress. Many of Pearl Jam’s most loyal fans are teenagers who do not have the money to pay the $50 or more that is often charged today for tickets to a popular concert. Although, given our popularity, we could undoubtedly continue to sell out our concerts with ticket prices at that premium level, we have made a conscious decision that we do not want to put the price of our concerts out of the reach of many of our fans.... For these reasons, we have attempted to keep the ticket prices to our concerts to a maximum of $18.... Even where a service charge is imposed, our goal is... that no one will pay more than $20 to see a Pearl Jam concert. Our efforts to try to keep prices... to this low level and to limit the possibility of excessive service charge mark-ups have put us at odds with TicketMaster... a nationwide computerized ticket distribution service that has a virtual monopoly on the distribution of tickets to concerts in this country. Thinking Economically How would placing a ceiling on the price of Pearl Jam concert tickets have affected demand and supply? Explain your answer based on
the information in the document. 186 Chapter 6 FIGURE 6.15 CON ES B. Academic Study Marie Connolly and Alan Krueger, of Princeton University, compiled these data on concert ticket prices for their study “Rockonomics: The Economics of Popular Music.” 70 60 50 40 30 20 10 ) High Average Low Change in prices for economy in general 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Source: Journal of Labor Economics, 2005. 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1993 1992 Year Thinking Economically In what three years was the high price per ticket about the same as the low price in 2003? C. Online Newspaper Article TicketMaster hoped to increase profits by auctioning tickets online. This article discusses the program’s potential effect on ticket prices. TicketMaster Plans to Launch Ticket Auction The sky’s the limit, as bidders compete for the best seats in the house. Fed up with watching ticket scalpers and brokers rake in the huge bucks for prime seats at their venues, TicketMaster plans to debut an online auction program for choice seats to selected concerts and sports events later this year. The move may drive up the price of front row seats when they start going to the highest bidder, but some analysts say the impact would likely be minimal.... Princeton University economics professor Alan B. Krueger... called the open auction a “positive development.” “For the top artists, tickets are still sold below what the market would bear, even though prices have shot up over the last six years,” Krueger told POLLSTAR. “This is especially the case for the best seats in the most expensive cities. “If the auction is widely used, I suspect price variability will increase; we will see greater dispersion in prices across artists, across cities and seats for the same artist.”... Source: Pollstar.com Thinking Economically How might TicketMaster’s online auction program lead to market equilibrium for the best tickets? THINKING ECONOMICALLY Synthesizing 1. Do you think TicketMaster’s plan in document C would help or harm Pearl Jam’s wish “that no one will pay more than $20” to see them (document A)? Explain your answer. 2. What do you think happened to quantity supplied of tickets over the span of the graph in document B? Why? 3. In what year in Figure 6.15
did the high price for concert tickets hit $50—the high price that Pearl Jam speaks of in document A? What year was it $20—the desired price they mention? Demand, Supply, and Prices 187 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes CHAPTER 6 Assessment Seeking Equilibrium: Demand and Supply (pp. 164–173) 1. How does the concept of market equilibrium reflect the interaction of producers and consumers in a market? Complete the following activity either on your own paper or online at ClassZone.com 2. Why are surpluses and shortages examples of disequilibrium? Choose the key concept that best completes the sentence. Not all key concepts will be used. black market competitive pricing disequilibrium equilibrium price incentive market equilibrium minimum wage price ceiling price floor rationing shortage surplus 1 is a situation that occurs when quantity demanded and quantity supplied at a particular price are equal. The price at which that situation occurs is the 2. If quantity supplied is greater than quantity demanded, a 3 occurs. If quantity demanded exceeds quantity supplied, then a 4 occurs. When a producer enters a market at a lower price (hoping to increase its customer base while maintaining profits by selling more units), it is engaging in 5. Rising prices are 6 that draws producers into markets. Sometimes government intervenes in the price system. A 7 is the legal maximum that producers may charge for certain goods or services. A 8 is the legal minimum amount that may be paid for a particular good or service. When certain goods or resources are scarce, the government may institute a system of 9, using some criteria besides price to allocate resources. An unplanned consequence of this action by the government is the development of a 10, where goods are bought and sold illegally. 188 Chapter 6 Prices as Signals and Incentives (pp. 174–179) 3. How are producers and consumers equally involved in the price system? 4. When do prices serve as signals and incentives for producers to enter a market? Intervention in the Price System (pp. 180–187) 5. What is the usual result of a price floor? 6. What motivates producers and consumers in the black market? A P P LY Look at the table below showing prices and sales figures for VCRs between 1998 and 2003. 7. Why did dollar sales increase between 1998 and 1999? 8. What is the trend in the average unit price of VCR
s between 1998 and 2003? What does this trend signal? FIGURE 6.16 VC R SALES TO DE ALERS Unit Sales (in thousands) Sales (in millions $) Average Unit Price ($) 1998 1999 2000 2001 2002 18,113 22,809 23,072 14,910 13,538 2003* 11,916 2,049 2,333 1,869 1,058 826 727 113 102 81 71 61 61 * projected Source: Consumer Electronics Association Market Research, January, 2003. Creating Graphs Suppose that you are the owner of a toy store. Create demand and supply curves for three products that you expect will sell well during the upcoming holiday shopping season. Then consider the following scenarios: one product becomes much more popular than you expected, one is much less popular than you expected, and the third loses half of its production capacity when a factory is leveled by an earthquake. Draw an additional curve on each of your graphs to show the change in demand or supply represented by these scenarios. Under each graph write a caption explaining the change shown and the effect on the equilibrium price. Use to complete this activity. @ ClassZone.com 10. Analyzing Effects Consumer concerns about nutrition and obesity contribute to a decrease in white bread sales and an increase in sales of whole wheat bread. This change in consumer taste prompts a major manufacturer known for its white bread to enter the market with a whole wheat bread product. What effect will this action have on the supply and equilibrium price of whole wheat bread? 11. Using Economic Concepts In 2004, the price of U.S. butter imports increased by more than 30 percent compared to the previous year. In 2003, Canada and New Zealand together supplied more than 80 percent of the butter imported into the United States. In 2004, their combined market share decreased to about 67 percent. What happened in the market to cause this change? How did price serve as a signal and incentive to producers? 12. Analyzing Effects How would U.S. government price supports for U.S.-made tennis rackets affect producers and consumers? 13. Challenge How would elasticity of demand help producers decide whether competitive pricing is a good strategy for their businesses Find the Best Price Step 1 Form a group with five other students. Imagine that together you are the market for jeans. Three are buyers and three are sellers, according to the following table. Your goal is to bargain with one another for a pair of jeans. Buyers try to get the lowest price possible, without going above their maximum, and
sellers try to get the highest price possible, without going below their minimum. SIX- PERSON JE ANS MARKE T Price ($) A B C D E F 20 30 40 15 25 35 Maximum price you are willing to pay for a pair of jeans Minimum price you are willing to sell a pair of jeans for Buyers Sellers Step 2 Choose a letter to determine your role. On a piece of paper write your letter and name, identify yourself as a buyer or seller, and show the dollar amount from the table. Step 3 Keep track of each proposed transaction in order on a sheet of paper. Recall what you know about demand, supply, and competitive pricing as you bargain to see who will buy and sell jeans and at what price. Bargaining ends when you reach equilibrium. What is quantity and price at equilibrium? Step 4 Use the information on the chart to create a demand and supply curve for this market. Does the curve reflect your group’s bargaining experience? Step 5 As a class, discuss what you learned from this exercise about how markets reach equilibrium. Use to complete this activity. @ ClassZone.com Demand, Supply, and Prices 189 Market Structures In markets where businesses offer similar products, sellers compete by trying to make their products stand out from the competition. 190 CHAPTER 7 Market Structures SECTION 1 What Is Perfect Competition? SECTION 2 The Impact of Monopoly SECTION 3 Other Market Structures SECTION 4 Regulation and Deregulation Today CASE STUDY Competition in Gadgets and Gizmos Competition involves all the actions that sellers, acting independently, take to get buyers to purchase their products market structure is an economic model that helps economists examine the nature and degree of competition among businesses in the same industry AT T E R S On trips to the mall, you’ve probably noticed something about the prices of products you’re looking to buy. If there are several different brands of the same kind of product, prices tend to be lower. If there’s just one brand, however, prices tend to be higher. The level of competition in a market has a major impact on the prices of products. The more sellers compete for your dollars, the more competitive prices will be. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on competition in the cellular telephone industry. (See Case Study, pp. 220–221.) Go to SMART GRAPHER to complete graphing activities in this chapter. Go to INTERACTIVE REVIEW for concept review
and activities. How do cellular phone makers compete for your business? See the Case Study on pages 220–221. Market Structures 191 S E C T I O N 1 What Is Perfect Competition TA K I N G N O T E S In Section 1, you will market structure, p. 192 • learn that perfect competition perfect competition, p. 192 standardized product, p. 192 price taker, p. 193 imperfect competition, p. 195 is the ideal by which economists measure all market structures • explain the characteristics of perfect competition and why it does not exist in the real world • analyze examples of markets that come close to perfect competition As you read Section 1, complete a cluster diagram to identify the major characteristics of perfect competition. Use the Graphic Organizer at Interactive Review @ ClassZone.com Perfect Competition The Characteristics of Perfect Competition KEY CONCEPT S When you buy new clothes, you probably shop around for the best deal. But when you buy milk, you know that a gallon will be about the same price no matter where you shop. The market for clothes has a different level of competition than the market for milk. Economists classify markets based on how competitive they are. A market structure is an economic model that allows economists to examine competition among businesses in the same industry. Perfect competition is the ideal model of a market economy. It is useful as a model, but real markets are never perfect. Economists assess how competitive a market is by determining where it falls short of perfect competition. Perfect competition has five characteristics. 1. Numerous buyers and sellers. No one seller or buyer has control over price. 2. Standardized product. Sellers offer a standardized product—a product that consumers consider identical in all essential features to other products in the same market. 3. Freedom to enter and exit markets. Buyers and sellers are free to enter and exit the market. No government regulations or other restrictions prevent a business or customer from participating in the market. Nor is a business or customer required to participate in the market. 4. Independent buyers and sellers. Buyers cannot join other buyers and sellers cannot join other sellers to influence prices. QUICK REFERENCE A market structure is an economic model of competition among businesses in the same industry. Perfect competition is the ideal model of a market economy. A standardized product is one that consumers see as identical regardless of producer. 192 Chapter 7 5. Well-informed buyers and sellers. Both buyers and sellers are well-informed about market conditions. Buyers can do comparison shopping, and sellers can learn
what their competitors are charging. When these five conditions are met, sellers become price takers. A price taker is a business that cannot set the prices for its products but, instead, accepts the market price set by the interaction of supply and demand. Only efficient producers make enough money to serve perfectly competitive markets. QUICK REFERENCE A price taker is a business that accepts the market price determined by supply and demand. C HAR ACTERISTIC 1 Many Buyers and Sellers A large number of buyers and sellers is necessary for perfect competition so that no one buyer or seller has the power to control the price in the market. When there are many sellers, buyers can choose to buy from a different producer if one tries to raise prices above the market level. But because there are many buyers, sellers are able to sell their products at the market price. Let’s consider the Smith family, whom you met in Chapter 5. The Smiths grow raspberries in the summer to sell at the Montclair Farmers’ Market. Because many farmers grow and sell raspberries at the same market, all of the farmers charge about the same price. If one farmer tries to charge more than the market price for raspberries, consumers will buy from the other farmers. Because there are many buyers—in other words, sufficient demand—the Smiths and other producers know that they can sell their product at the market price. Lack of demand will not cause them to lower their prices. C HAR ACTERISTIC 2 Standardized Product In perfect competition, consumers consider one producer’s product essentially the same as the product offered by another. The products are perfect substitutes. Agricultural products such as wheat, eggs, and milk, as well as other basic commodities such as notebook paper or gold generally meet this criterion. Considering the Montclair Farmers’ Market, while no two pints of raspberries are exactly alike, they are similar enough that consumers will choose to buy from any producer that offers raspberries at the market price. Price becomes the only basis for a consumer to choose one producer over another. Perfect Competition Farmers’ markets exhibit many of the characteristics of perfect competition. C HAR ACTERISTIC 3 Freedom to Enter and Exit Markets In a perfectly competitive market, producers are able to enter the market when it is profitable and to exit when it becomes unprofitable. They can do this because the investment that a producer makes to enter a market is relatively low. Market forces alone encourage producers to freely enter or
leave a given market. The Smiths and other farmers consider the market price for raspberries when planning their crops. If they believe they can make a profit at that price, they grow raspberries. If not, they try some other crop. Find an update about perfect competition at ClassZone.com Market Structures 193.1 Characteristics of Perfect Competition Many Buyers and Sellers A large number of buyers and sellers ensures that no one controls prices. Well-informed Buyers and Sellers Both buyers and sellers know the market prices and other conditions. Characteristics of Perfect Competition? What Are the Standardized Products All products are essentially the same. Freedom to Enter and Exit Markets Producers can enter or exit the market with no interference. Independent Buyers and Sellers Buyers and sellers do not band together to influence prices. ANALYZE CHARTS Imagine that you own a farm and that you have decided to sell raspberries at the Montclair Farmers’ Market. Construct your own diagram to show how the five characteristics of perfect competition will apply to your enterprise. CHARACTERISTIC 4 Independent Buyers and Sellers In a perfectly competitive market, neither buyers nor sellers join together to influence price. When buyers and sellers act independently, the interaction of supply and demand sets the equilibrium price. Independent action ensures that the market will remain competitive. At the Montclair Farmers’ Market, the farmers do not band together to raise prices, nor do the consumers organize to negotiate lower prices. CHARACTERISTIC 5 Well-informed Buyers and Sellers Buyers and sellers in a perfectly competitive market have enough information to make good deals. Buyers can compare prices among different sellers, and sellers know what their competitors are charging and what price consumers are willing to pay. Buyers and sellers at the Montclair Farmers’ Market make informed choices about whether to buy or sell raspberries in that market. With all five characteristics met, the Smiths accept the market price for raspberries. All raspberry producers become price takers. APPLICATION Making Inferences A. Can you think of another market that comes close to perfect competition? Which of the characteristics does it lack? 194 Chapter 7 Competition in the Real World KEY C ONCEPT S In the real world, there are no perfectly competitive markets because real markets do not have all of the characteristics of perfect competition. Market structures that lack one of the conditions needed for perfect competition are examples of imperfect competition. (You’ll learn more about imperfect competition in Sections 2
and 3.) However, there are some markets—the wholesale markets for farm products such as corn and beef, for example—that come close to perfect competition. QUICK REFERENCE Imperfect competition occurs in markets that have few sellers or products that are not standardized. E XAMPLE 1 Corn In the United States, there are thousands of farmers who grow corn, and each one contributes only a small percentage of the total crop. Therefore, no one farmer can control the price of corn, and all farmers accept the market price. Individual farmers decide only how much corn to produce to offer for sale at that price. At the same time, there are a large number of buyers, and the price on the wholesale market is easy to determine. Corn is a fairly standardized product, and buyers usually have no reason to prefer one farmer’s corn to another’s. Buyers will not pay more than the market price. In reality, there are several reasons that imperfect competition occurs in the corn market. For one thing, the U.S. government pays subsidies to corn farmers to protect them from low corn prices. In addition, sometimes corn farmers band together to try to influence the price of corn in their favor, and corn buyers sometimes pursue the same strategy. Subsidies, group action, and other deviations from perfect competition interfere with the market forces of supply and demand. E XAMPLE 2 Beef The wholesale market for raw beef is another that comes close to perfect competition. There are many cattle producers, and there is little variation in a particular cut of beef from one producer to the next. Because the beef is so similar, the wholesale buyer’s primary concern will be price. Both buyers and sellers can easily determine the market price, and producers sell all their beef at that price. Cattle sellers can adjust only their production to reflect the market price. As in the corn market, there are several reasons that imperfect competition occurs in the beef market. Cattle ranchers, like corn farmers, may try to join together to influence the price of beef in their favor. In addition, many beef producers try to persuade buyers that there are significant differences in their products that warrant higher prices. For example, cattle that eat corn supposedly produce better tasting beef. AP P LI CATION Drawing Conclusions B. Why is the market for corn closer to perfect competition than the market for corn flakes? Close to Perfect Competition Wholesale markets for agricultural products, such as corn, come close to perfect competition. Market Structures 195 For
more information on creating and interpreting economic models, see the Skillbuilder Handbook, page R16. Creating and Interpreting Economic Models Economic models help solve problems by focusing on a limited set of variables. A production costs and revenue schedule, which you learned about in Chapter 5, is a model that helps businesses decide how much to produce. Creating a graph as part of the model paints a picture of the data that makes it easier to understand. In this example, imagine you own a business that produces baseballs in a perfectly competitive market. The market price of a baseball is $1, but your costs vary depending on how many you produce. Follow the instructions to create a graph that will help you visualize the way a perfectly competitive market works. CREATING AN ECONOMIC MODEL OF BASEBALL PRODUCTION 1. Copy the graph below onto your own paper, or use @ ClassZone.com. 2. Using data from the table below, plot the curve showing the marginal costs of producing different numbers of baseballs. Label the curve “MC.” 3. Using data from the table below, plot the curve showing the marginal revenue of producing different numbers of baseballs. Label the curve “MR.” BASEBALL PRODUCTION COSTS AND REVENUES SCHEDULE Total Produced Total Revenue (in dollars) Total Cost (in dollars 10 11 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00 1.00 2.00 2.80 3.50 4.00 4.50 5.20 6.00 6.86 7.86 9.36 11.50 Total Profit (in dollars) 21.00 21.00 20.80 20.50 0.00 0.50 0.80 1.00 1.14 1.14 0.64 20.50 Marginal Revenue (in dollars) Marginal Cost (in dollars) — 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 — 1.00 0.80 0.70 0.50 0.50 0.70 0.80 0.86 1.00 1.50 2.14 BA SEBALL PRODUC T I ON 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 ) 10
11 Quantity of baseballs T HINKING ECONOMICALLY Analyzing 1. How many baseballs should you produce each day to maximize profits? 2. Using the same graph, plot the demand curve for this perfectly competitive market. Remember that the market price will not change no matter how many baseballs are demanded. 3. How does the graph help explain the term “price takers”? 196 Chapter 7 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. market market structure b. perfect competition imperfect competition 2. Why are sellers in a perfectly competitive market known as price takers? 3. Why is it necessary to have standardized products in order to have perfect competition? 4. Why is independent action of buyers and sellers important to achieving perfect competition? 5. How is imperfect competition different from perfect competition? 6. Using Your Notes What are the five characteristics of perfect competition? Refer to your completed cluster diagram. Perfect Competition Use the Graphic Organizer at Interactive Review @ ClassZone.com. Drawing Conclusions Suppose that you went to a farmers’ market and found several different farmers selling cucumbers. Would you be likely to find a wide range of prices for cucumbers? Why or why not? 8. Analyzing Effects What would happen to a wheat farmer who tried to sell his wheat for $2.50 per bushel if the market price were $2.00 per bushel? Why? 9. Making Inferences Why are brand-name products not found in a perfectly competitive market? You will learn more about this topic in Section 3 of this chapter. 10. Challenge At an auction, sellers show their goods before an audience of buyers. The goods for sale may be similar to each other, as in an auction of used cars, or they may be one-of-a-kind, as in an art auction. Buyers usually have an opportunity to inspect items prior to the auction. During the auction, buyers bid against one another to see who is willing to pay the highest price. In what ways is an auction similar to a perfectly competitive market? In what ways is it different? How competitive is the market for snowboards? Identifying Perfect Competition Perfectly competitive markets can be identified by specific characteristics. The chart below lists these characteristics. Characteristics of Perfect Competition Markets Many buyers and sellers Standardized product Freedom to enter and leave the market Independent action Well-informed buyers and sellers Complete a
Chart Five different markets are shown in the chart. On your own paper, complete the chart by marking which of the characteristics each market has. Challenge Choose one market from the chart and explain what would need to be done to make it perfectly competitive. Market Structures 197 S E C T I O N 2 The Impact of Monopoly TA K I N G N O T E S In Section 2, you will monopoly, p. 198 • describe the characteristics of cartel, p. 198 a monopoly • analyze four different types of monopolies and discuss how they come about • explain how a monopoly sets its prices and production goals price maker, p. 198 barrier to entry, p. 198 natural monopoly, p. 201 government monopoly, p. 201 technological monopoly, p. 201 geographic monopoly, p. 201 economies of scale, p. 201 patent, p. 202 As you read Section 2, complete a chart to show how different types of monopolies exhibit the characteristics of monopoly. Use the Graphic Organizer at Interactive Review @ ClassZone.com One Seller Restricted Market Control of Prices Natural Monopoly Government Monopoly Technological Monopoly Geographic Monopoly Characteristics of a Monopoly KEY CONCEPT S Perfect competition is the most competitive market structure. The least competitive is monopoly, a market structure in which only one seller sells a product for which there are no close substitutes. The term monopoly may be used for either the market structure or the monopolistic business. Pure monopolies are as rare as perfect competition, but some businesses come close. For example, a cartel is a formal organization of sellers or producers that agree to act together to set prices and limit output. In this way, a cartel may function as a monopoly. Because a monopoly is the only seller of a product with no close substitutes, it becomes a price maker, a business that does not have to consider competitors when setting its prices. Consumers either accept the seller’s price or choose not to buy the product. Other firms may want to enter the market, but they often face a barrier to entry—something that hinders a business from entering a market. Large size, government regulations, or special resources or technology are all barriers to entry. Let’s take a closer look at the three characteristics of monopoly through the De Beers cartel, which held a virtual monopoly on the diamond market for most of the 20th century. At one time it controlled as much as 80 percent of the market in uncut diamonds. De Beers used its monopoly power to control the price of diamonds
and created barriers to entry that kept other firms from competing. QUICK REFERENCE Monopoly occurs when there is only one seller of a product that has no close substitutes. A cartel is a group that acts together to set prices and limit output. A price maker is a firm that does not have to consider competitors when setting the prices of its products. A barrier to entry makes it hard for a new business to enter a market. 198 Chapter. 2 Characteristics of a Monopoly What Are the Characteristics of a Monopoly? T E K M RESTRICTED A R Only One Seller A single business controls the supply of a product that has no close substitutes. Control of Prices Monopolies act as price makers because they sell products that have no close substitutes and they face no competition. Restricted, Regulated Market Government regulations or other barriers to entry keep other firms out of the market. ANALYZE CHARTS Imagine that you are a business person with unlimited funds. Could you gain a monopoly over the market for housing in your neighborhood? Using the chart, explain the steps you would need to take. How might your neighborhood change if one person controlled property prices? C HAR ACTERISTIC 1 Only One Seller In a monopoly, a single business is identified with the industry because it controls the supply of a product that has no close substitutes. For example, De Beers once produced more than half of the world’s diamond supply and bought up diamonds from smaller producers to resell. In this way, it controlled the market. C HAR ACTERISTIC 2 A Restricted, Regulated Market In some cases, government regulations allow a single firm to control a market, such as a local electric utility. In the case of De Beers, the company worked with the South African government to ensure that any new diamond mines were required to sell their diamonds through De Beers. The company also restricted access to the market for raw diamonds for producers outside of South Africa. By controlling the supply of diamonds, De Beers made it difficult for other producers to make a profit. C HAR ACTERISTIC 3 Control of Prices Monopolists can control prices because there are no close substitutes for their product and they have no competition. When economic downturns reduced demand for diamonds, De Beers created artificial shortages by withholding diamonds from the market. The reduced supply allowed the cartel to continue charging a higher price. AP P LI CATION Analyzing Effects A. What effect did the De Beers diamond monopoly have on the
price of diamonds? Market Structures 199 OPEC: Controlling the Oil Pipelines The Organization of the Petroleum Exporting Countries (OPEC) does not have a monopoly on oil reserves or oil production. However, the 11 member nations of the cartel possess more than two-thirds of the world’s oil reserves and produce about two-fifths of the world’s oil supply. By regulating the amount of oil that flows through its pipelines, OPEC exerts control over the market price for oil. Market forces often counteract OPEC’s supply adjustments. For example, in the early 1980s demand for oil fell as consumers and businesses implemented strategies to reduce energy use. Despite OPEC’s efforts to reduce supply and stabilize the price, crude oil prices fell through most of the 1980s. Another factor that limits OPEC’s control over oil prices is member unity. Members sometimes choose not to follow OPEC moves to reduce oil output—because that would reduce their revenues. Despite these limitations, OPEC continues to play a major role in the world market for petroleum. F I G U R E 7. 4 OPEC Member Nations FIGURE 7. 3 OPEC MEMBERS Country Joined OPEC Location Algeria Indonesia Iran Iraq Kuwait Libya Nigeria Qatar 1969 Africa 1962 Asia 1960 Middle East 1960 Middle East 1960 Middle East 1962 Africa 1971 Africa 1961 Middle East Saudi Arabia 1960 Middle East United Arab Emirates 1967 Middle East Venezuela 1960 South America Source: OPEC ARCTIC OCEAN IRAQ Neutral Zone I RAN UNITED ARAB EMIRATES KUWAIT P e r sia n Gulf ATLANTIC OCEAN ALGERIA LIBYA IRAQ I R A N SAUDI ARABIA KUWAIT QATAR U.A.E. VENEZUELA NIGERIA QATAR SA UDI A RAB I A PA INDONESIA ATLANTIC OCEAN OPEC nations CONNECTING ACROSS THE GLOBE 1. Applying Economic Concepts In what ways does OPEC act like a monopoly? 2. Making Inferences What will happen to OPEC’s monopolistic power as the world discovers new sources of energy? Explain your answer. 200 Chapter 7 Types of Monopolies KEY C ONCEPT S There are several reasons why monopolies exist, and not all monopolies are harmful to consumers. A natural monopoly is a market situation in which the costs of production are lowest when only one firm provides output. A government monopoly is a monopoly that exists because the government either owns and runs
the business or authorizes only one producer. A technological monopoly is a monopoly that exists because the firm controls a manufacturing method, an invention, or a type of technology. A geographic monopoly is a monopoly that exists because there are no other producers or sellers within a certain region. E XAMPLE 1 Natural Monopoly: A Water Company In some markets, it would be inefficient to have more than one company competing for consumers’ business. Most public utilities fall into this category. Let’s look at the water company in your community as an example. It pumps the water from its source through a complex network of pipes to all the homes, businesses, and public facilities in the community. It also monitors water quality for safety and removes and treats wastewater so that it may be recycled. It would be a waste of community resources to have several companies developing separate, complex systems in order to compete for business. A single supplier is most efficient due to economies of scale, a situation in which the average cost of production falls as the producer grows larger. The more customers the water company serves, the more efficient its operation becomes, as its high fixed costs are spread out over a large number of buyers. These economies of scale result in government support for natural monopolies. While supporting natural monopolies, the government also regulates them to ensure that they do not charge excessively high prices for their services. E XAMPLE 2 Government Monopoly: The Postal Service Government-run businesses provide goods and services that either could not be provided by private firms or that are not attractive to them because of insufficient profit opportunities. One of the oldest government monopolies in the United States is the U.S. Postal Service, which has the exclusive right to deliver first-class mail. Originally, only the government could provide this service in an efficient and costeffective manner. However, new services and new technologies have been chipping away at this monopoly. Private delivery companies offer services that compete with the U.S. Postal Service. Many people now send information by fax, e-mail, and text messages. In addition, many pay their bills online. QUICK REFERENCE A natural monopoly occurs when the costs of production are lowest with only one producer. A government monopoly exists when the government either owns and runs the business or authorizes only one producer. A technological monopoly occurs when a firm controls a manufacturing method, invention, or type of technology. A geographic monopoly exists when there are no other producers within a certain region. Economies of scale occur when the average cost of
production falls as the producer grows larger. Natural Monopolies Most public utilities require complex systems, such as this water treatment facility. Market Structures 201 YO U R EC GOVERNM ENT MONO POLY Which mail service will you choose? If you need to send thank-you notes, you could send them by regular mail, which is a government monopoly. Or you could send electronic thank-you notes by computer.? ▲ E-mail message ▲ Handwritten note QUICK REFERENCE A patent gives an inventor the exclusive property rights to that invention or process for a certain number of years. EXAMPLE 3 Technological Monopoly: Polaroid In 1947, Edwin Land, the founder of the Polaroid Corporation, invented the first instant camera. Land’s camera used a special type of film that allowed each picture to develop automatically in about a minute. Through a series of patents, Polaroid created a monopoly in the instant photography market. A patent is a legal registration of an invention or a process that gives the inventor the exclusive property rights to that invention or process for a certain number of years. The government supports technological monopolies through the issuing of patents. Through patents, businesses are able to recover the costs that were involved in developing the invention or technology. Polaroid’s control of instant photography technology through its patents was a barrier to entry for other firms. In 1985, Polaroid won a lawsuit against Eastman Kodak Company for patent infringement. The court ruled that Kodak’s instant camera and film had violated Polaroid’s property rights, which were protected by several patents. The lawsuit effectively blocked Kodak from the instant photography market. Technological monopolies last only as long as the patent—generally 20 years—or until a new technology creates close substitutes. The rise of easier-to-use 35mm cameras, onehour photo processing, and digital cameras all contributed to a steep decline in Polaroid’s business. While the company remains the leading seller of instant cameras and film, the technology has become a minor segment of the consumer photography market. Technological Monopoly Polaroid instant cameras use patented technology. 202 Chapter 7 E XAMPLE 4 Geographic Monopoly: Professional Sports One type of geographic monopoly in the United States is the professional sports team. The major sports leagues require that teams be associated with a city or region and limit the number of teams in each league. In other words, the leagues create a restricted market for professional sports. Most cities and towns are
not directly represented by a team, so many teams draw their fans from a large surrounding geographic region. Because of their geographic monopolies, the owners of these teams are able to charge higher prices for tickets to games than if they faced competition. They also have a ready market for sports apparel and other merchandise featuring the team logo and colors. Another type of geographic monopoly is created by physical isolation. For example, Joe operates the only gas station at an interstate exit in the middle of a desert. The next station in either direction is more than 50 miles away. Joe has a geographic monopoly because he is the only supplier of a product with no close substitutes. Drivers on the interstate in that area depend on Joe’s gas and have no other choice of supplier. They can either buy gas from Joe or risk running out of gas before they reach the next station. Because of his geographic location as the single supplier of a product that has no close substitutes, Joe is able to control the price that he charges—and gas at Joe’s is always very expensive. Geographic Monopolies The Boston Red Sox is the only baseball team in New England, so it draws fans from across the six-state region. Isolated locations or small communities may have other examples of geographic monopolies if the market is too small to support two similar businesses. Geographic monopolies have become less common in the United States. Cars allow people to travel greater distances to shop, and catalog marketers and Internet businesses, combined with efficient delivery companies, offer consumers more alternatives to shopping at local stores. AP P LI CATION Drawing Conclusions B. Which type of monopoly do you think is least harmful to consumers? Why? Find an update on monopolies at ClassZone.com Market Structures 203 Profit Maximization by Monopolies KEY CONCEPT S Although a monopoly firm is the only supplier in its market, the firm cannot charge any price it wishes. A monopolist still faces a downward-sloping demand curve. In other words, the monopoly will sell more at lower prices than at higher prices. The monopolist controls price by controlling supply. A monopoly produces less of a product than would be supplied in a competitive market, thereby artificially raising the equilibrium price. It’s difficult to study this process in the real world because most countries have laws to prevent monopolies. We have to look at small instances in which a company has a monopoly over one particular specialized product. Such a limited monopoly lasts only for the life of the patent or until a competitor develops a similar
product. EXAMPLE Drug Manufacturer Pharmaceutical manufacturers offer an example of how companies with limited monopolies try to maximize their profits. On average, drug patents last for about 11 years in the United States. Drug companies try to maximize their profits during that period because when the patent expires they face competition from other manufacturers who begin marketing generic versions of the drug. A generic drug contains the same ingredients and acts in the same way as the patented drug, but it is sold at much lower prices. As an example, consider the Schering-Plough company and its antihistamine Claritin. The drug was originally approved for use as a prescription medication in the United States in 1993, although it had been patented earlier. Unlike many other such drugs, Claritin did not make users drowsy. This advantage, combined with a strong marketing campaign, led Claritin to become a top seller, making as much as $3 billion in annual worldwide sales. When the patent on Claritin expired in 2002, numerous generic equivalents entered the market. In response, Schering-Plough lowered Claritin’s price and gained approval for a nonprescription form of the drug. But sales of Claritin fell to about $1 billion as consumers switched to less costly generic equivalents. APPLICATION Applying Economic Concepts C. Using the three characteristics of monopoly, explain what happened to the market for Claritin when its patent expired. 204 Chapter 7 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. monopoly cartel b. natural monopoly geographic monopoly c. technological monopoly government monopoly 2. What is the relationship between economies of scale and a natural monopoly? 3. How does a patent awarded to one company act as a barrier to entry to another company wishing to enter the same market? 4. Why is a monopolist a price maker rather than a price taker? 5. Why do technological monopolies exist only for a limited time? One Seller Restricted Market Control of Prices 6. Using Your Notes Why is a geographic monopoly able to control the price of its product? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com Natural Monopoly Government Monopoly Technological Monopoly Geographic Monopoly 7. Analyzing Causes and Effects Companies that produce generic drugs are not required to repeat the clinical tests that the original manufacturer of the drug is required to run before the drug receives its patent. How
does this fact affect the prices of generic drugs and why? 8. Analyzing Effects A powerful monopoly is broken up into several smaller, competing companies. What are the costs and benefits for the general public? 9. Drawing Conclusions In 2003, 95 percent of the households in America had access to only one cable TV company in their area. What kind of monopoly did cable TV companies have? Explain your answer. 10. Challenge Among the drugs to fight high cholesterol, the most effective are known as statins. The drugs are similar, but each is different enough to have its own patent. In 2005, there were seven such drugs on the market. In 2006, the patents ended for two of the drugs. What effect did this have on the entire category of statin drugs, including those whose patents were still in effect through 2006? Explain why this might be the case. Identifying Types of Monopolies You learned in this section that there are four types of monopolies: natural, government, technological, and geographical. What Type? The table below lists examples of several monopolies. For each example, identify the type of monopoly. Some types have more than one example. Type of Monopoly Example of Monopoly U.S. interstate highway system Electric utility company The only bank in a small town The company that received a patent for the Frisbee A city’s public transportation system Natural gas company Challenge In which type of monopoly is the government least likely to be involved? Give reasons for your answer. Market Structures 205 S E C T I O N 3 Other Market Structures TA K I N G N O T E S In Section 3, you will monopolistic competition, p. 206 • learn that monopolistic product differentiation, p. 206 competition and oligopoly are market structures that fall between perfect competition and monopoly • identify the characteristics of monopolistic competition • describe the characteristics of oligopoly nonprice competition, p. 207 focus group, p. 208 oligopoly, p. 209 market share, p. 209 start-up costs, p. 209 As you read Section 3, complete a chart to compare and contrast monopolistic competition and oligopoly. Use the Graphic Organizer at Interactive Review @ ClassZone.com Monopolistic Competition Oligopoly Characteristics of Monopolistic Competition QUICK REFERENCE Monopolistic competition occurs when many sellers offer similar, but not standardized, products. Product differentiation is the effort to distinguish a product from similar products. KEY CONCEPT S Most markets in the real world fall somewhere between
the models of perfect competition and monopoly. One of the most common market structures is monopolistic competition, in which many sellers offer similar, but not standardized, products. The market for T-shirts printed with images or slogans is one example. The market is competitive because there are many buyers (you, your friends, and many other buyers) and many sellers (stores at the mall, online merchants, sports teams, and many other sellers). The market is monopolistic because each seller has influence over a small segment of the market with products that are not exactly like those of their competitors. Someone looking for a pink T-shirt with fuzzy kittens would not accept a black monster-truck rally Tshirt as a close substitute. Product differentiation and nonprice competition are the distinguishing features of monopolistic competition. Product differentiation is the attempt to distinguish a product from similar products. Sometimes, the effort focuses on substantial differences between products, such as vehicle gas mileage ratings. 206 Chapter 7 But companies also try to differentiate their products when there are few real differences between products. For example, a battery company might spend millions of dollars on advertising to convince consumers that their batteries last longer than other batteries—even though the real difference in longevity may be minimal. Another way companies in monopolistic competitive markets try to gain business is through nonprice competition. Nonprice competition means using factors other than low price—such as style, service, advertising, or giveaways—to try to convince customers to buy one product rather than another. If you’ve ever decided to eat at a particular fast food restaurant just to get the cool gizmo it’s giving away, you have participated in nonprice competition. Monopolistic competition has four major characteristics: many buyers for many sellers, similar but differentiated products, limited lasting control over prices, and freedom to enter or exit the market. Let’s take a closer look at each of these characteristics by focusing on the market for hamburgers. C HAR ACT ER IST IC 1 Many Sellers and Many Buyers In monopolistic competition there are many sellers and many buyers. The number of sellers is usually smaller than in a perfectly competitive market but sufficient to allow meaningful competition. Sellers act independently in choosing what kind of product to produce, how much to produce, and what price to charge. When you want a hamburger, you have many different restaurants from which to choose. The number of restaurants assures that you have a variety of kinds of hamburgers to choose from and that prices will be competitive. No single
seller has a large enough share of the market to significantly control supply or price. However, there are probably a few restaurants that make burgers you really like and others with burgers you really don’t like. The restaurants that make your favorite burgers have a sort of monopoly on your business. C HAR ACTERISTIC 2 Similar but Differentiated Products Sellers in monopolistic competition gain their limited monopoly-like power by making a distinctive product or by convincing consumers that their product is different from the competition. Hamburger restaurants might advertise the quality of their ingredients or the way they cook the burger. They might also use distinctive packaging or some special service—a money-back guarantee if the customer is not satisfied with the meal, for example. One key method of product differentiation is the use of brand names, which QUICK REFERENCE Nonprice competition occurs when producers use factors other than low price to try to convince customers to buy their products. Find an update about monopolistic competition at ClassZone.com Hamburger Valhalla Chili-Cheese Burger White bread bun Cheese and chili All-beef patty Standard pickles, onions, tomatoes, lettuce Healthy Eats Veggie Burger Whole wheat bun Organic pickles, onions, tomatoes Veggie patty Organic lettuce Market Structures 207 encourage consumer loyalty by associating certain desirable qualities with a particular brand of hamburger. Producers use advertising to inform consumers about product differences and to persuade them to choose their offering. How do hamburger restaurants decide how to differentiate their products? They conduct market research, the gathering and evaluation of information about consumer preferences for goods and services. For local restaurants, market research may be limited to listening to their customers’ praise or complaints and paying attention to what competing restaurants offer. The large chain restaurants can afford to use more sophisticated research techniques to gain information about consumers’ lifestyles and product preferences. One technique is the focus group—a moderated discussion with small groups of consumers. Another market research technique is the survey, in which a large number of consumers are polled, one by one, on their opinions. The results of market research help the restaurants differentiate their hamburgers and attract more customers. CH A R A CT ER IST IC 3 Limited Control of Prices Product differentiation gives producers limited control of price. Hamburger restaurants charge different prices for their product depending on how they want to appeal to customers. The price of some hamburgers is set as low as possible to appeal to parents of younger eaters or to those on tight budgets. Prices for name-brand
hamburgers or burgers with better quality ingredients may be set slightly higher. If consumers perceive that the differences are important enough, they will pay the extra price to get the hamburger they want. Yet producers in monopolistic competition also know that there are many close substitutes for their product. They understand the factors that affect demand and recognize that consumers will switch to a substitute if the price goes too high. CHARACTERISTIC 4 Freedom to Enter or Exit Market There are generally no huge barriers to entry in monopolistically competitive markets. It does not require a large amount of capital for someone to open a hamburger stand, for example. When firms earn a profit in the hamburger market, other firms will enter and increase competition. Increased competition forces firms to continue to find ways to differentiate their products. The competition can be especially intense for small businesses facing much larger competitors. Some firms will not be able to compete and will start to take losses. This is the signal that it is time for those firms to exit the market. Leaving the restaurant market is relatively easy. The owners sell off the cooking equipment, tables, and other supplies at a discount. If their finances are solid, they may then look for another market where profits might be made. APPLICATION Applying Economic Concepts A. Think about an item of clothing that you purchased recently. How did the seller differentiate the product? List several ways, then compare lists with a classmate. QUICK REFERENCE A focus group is a moderated discussion with small groups of consumers. Ease of Entry and Exit In monopolistic competition, sellers may enter and exit the market freely. 208 Chapter 7 Characteristics of an Oligopoly KEY C ONCEPT S Oligopoly (OL-ih-GOP-ah-lee), a market structure in which only a few sellers offer a similar product, is less competitive than monopolistic competition. In an oligopoly, a few large firms have a large market share—percent of total sales in a market—and dominate the market. For example, if you want to see a movie in a theater, chances are the movie will have been made by one of just a few major studios. What’s more, the theater you go to is probably part of one of just a few major theater chains. Both the market for film production and the market for movie theaters are oligopolies. There are few firms in an oligopoly because of high start-up costs—the expenses that a new business must pay to enter a market and begin selling to consumers.
Making a movie can be expensive, especially if you want to make one that can compete with what the major studios produce. And getting it into theaters across the country requires a huge network of promoters and distributors—and even more money. An oligopoly has four major characteristics. There are few sellers but many buyers. In industrial markets, sellers offer standardized products, but in consumer markets, they offer differentiated products. The few sellers have more power to control prices than in monopolistic competition, but to enter or exit the market is difficult. C HAR ACTERISTIC 1 Few Sellers and Many Buyers In an oligopoly, a few firms dominate an entire market. There is not a single supplier as in a monopoly, but there are fewer firms than in monopolistic competition. These few firms produce a large part of the total product in the market. Economists consider an industry to be an oligopoly if the four largest firms control at least 40 percent of the market. About half of the manufacturing industries in the United States are oligopolistic. QUICK REFERENCE Oligopoly is a market structure in which only a few sellers offer a similar product. Market share is a company’s percent of total sales in a market. Start-up costs are the expenses that a new business faces when it enters a market. The Breakfast Cereal Industry Just a few large companies produce the majority of breakfast cereals available. The breakfast cereal industry in the United States is dominated by four large firms that control about 80 percent of the market. Your favorite cereal is probably made by one of the big four manufacturers. Although they offer many varieties of cereals, there is less competition than there would be if each variety were produced by a different, smaller manufacturer. C HAR ACTERISTIC 2 Standardized or Differentiated Products Depending on the market, an oligopolist may sell either standardized or differentiated products. Many industrial products are standardized, and a few large firms control these markets. Examples include the markets for steel, aluminum, and flat glass. When products are standardized, firms may try to differentiate themselves based on brand name, service, or location. Breakfast cereals, soft drinks, and many other consumer goods are examples of differentiated products sold by oligopolies. Oligopolists market differentiated prod- Market Structures 209 ucts using marketing strategies similar to those used in monopolistic competition. They use surveys, focus groups, and other market research techniques to find out what you like. The companies then create brand-name products that can be marketed
across the country or around the world. CHARACTERISTIC 3 More Control of Prices Because there are few sellers in an oligopoly, each one has more control over product price than in a monopolistically competitive market. For example, each breakfast cereal manufacturer has a large enough share of the market that decisions it makes about supply and price affect the market as a whole. Because of this, a seller in an oligopoly is not as independent as a seller in monopolistic competition. A decision made by one seller may cause the other sellers to respond in some way. For example, if one of the leading breakfast cereal manufacturers lowers its prices, the other manufacturers will probably also lower prices rather than lose customers to the competition. Therefore, no firm is likely to gain market share based on price, and all risk losing profits. But if one manufacturer decides to raise prices, the others may not follow suit, in order to take customers and gain market share. Consequently, firms in an oligopoly try to anticipate how their competitors will respond to their actions before they make decisions on price, output, or marketing. CHARACTERISTIC 4 Little Freedom to Enter or Exit Market Start-up costs for a new company in an oligopolistic market can be extremely high. Entering the breakfast cereal industry on a small scale is not very expensive—but the profits are low too. The factories, warehouses, and other infrastructure needed to compete against the major manufacturers require large amounts of funds. In addition, existing manufacturers may hold patents that act as further barriers to entry. Firms in an oligopoly have established brands and plentiful resources that make it difficult for new firms to enter the market successfully. For example, breakfast cereal manufacturers have agreements with grocery stores that guarantee them the best shelf space. Existing manufacturers also have economies of scale that help them to keep their expenses low. Smaller firms, with smaller operations, lack the economies of scale. However, all of the investments by firms in an oligopoly make it difficult for them to exit the market. When a major breakfast cereal manufacturer begins losing money, its operations are too vast and complex to sell and reinvest easily, as a small business might. It must trim its operations and work to stimulate demand for its product. APPLICATION Categorizing Information B. Which of these products produced by oligopolies are standardized and which are differentiated: automobiles, cement, copper, sporting goods, tires? Find an update about oligopolies at ClassZone.com High Start-up Costs New ﬁ rms may not
have the funds to construct large factories. 210 Chapter 7 Comparing Market Structures KEY C ONCEPT S Each of the four market structures has different benefits and problems. And each type creates a different balance of power—namely, the power to influence prices— between producers and consumers. Consumers get the most value in markets that approach perfect competition. No actual markets are perfectly competitive, but in those that come close, prices are set primarily by supply and demand. However, such markets usually deal in a standardized product, so consumers have little choice other than the best price. In monopolistic competition, consumers continue to benefit from companies competing for their business. But businesses gain some control over prices, so they are more likely to earn a profit. Opening a business in such a market is usually relatively affordable, which is another benefit for businesses. In markets dominated by oligopolies, consumer choices may be more limited than in more competitive markets. Businesses in such markets gain more control of price, making it easier for them to make a profit. However, the cost of doing business in such a market is high. A market ruled by a monopoly is very favorable for the business that holds the monopoly. It faces little or no competition from other companies. And monopoly gives consumers the least influence over prices. They decide only whether they are willing to buy the product at the price set by the monopolist. F I G U R E 7. 5 Comparing Market Structures Number of Sellers Type of Product Sellers’ Control over Prices Barriers to Enter or Exit Market Perfect Competition Many Standardized Monopolistic Competition Oligopoly Many Similar but differentiated None Limited Few Few Few Standardized for industry; Some Many Monopoly One differentiated for consumers Standardized, but no close substitutes Significant Very many—market restricted or regulated ANALYZE CHARTS 1. If you were starting a business, which market structures would make it easiest for you to enter the market? 2. Which market structures offer the highest potential profits? Why? AP P LI CATION Drawing Conclusions C. What difference does it make to consumers whether a market is ruled by monopolistic competition or by an oligopoly? Market Structures 211 ECO N O M I C S PAC ES E T T E R Joan Robinson: Challenging Established Ideas In this section, you learned about monopolistic competition and oligopoly. British economist Joan Robinson was one of the first to write about these market structures. As strange as it may seem to us now, most economists before 1930 described market
competition only in terms of the extremes of perfect competition and monopoly. Explaining Real-World Competition In 1933, Joan Robinson challenged the prevailing ideas about competition. Her first major book, The Economics of Imperfect Competition, described market structures that existed between monopoly and perfect competition. Robinson’s work appeared shortly after Harvard economist Edward Chamberlin published his book Theory of Monopolistic Competition. The two economists had developed their ideas independently. Robinson and Chamberlin described the type of competition that exists among firms with differentiated products. Such firms gain more control over the price of their product, but their control is limited by the amount of competition. They also described the nature of oligopoly and of monopsony, a market structure in which there are many sellers but only one large buyer. Robinson continued to contribute important ideas throughout her long career in economics. Her theory of imperfect competition remains a key element of the field of microeconomics today. Economists recognized that Robinson’s theory more accurately reflected modern market economies in which firms compete through product differentiation and advertising and in which many industries are controlled by oligopolies. Joan Robinson developed the theory of imperfect competition. APPLICATION Making Inferences D. Why do you think Joan Robinson chose the term imperfect competition to describe the nature of most real-world markets? FAST FACTS Joan Robinson Career: Economics professor, Cambridge University Born: October 31, 1903 Died: August 5, 1983 Major Accomplishment: Developed theory of imperfect competition Books: The Economics of Imperfect Competition (1933), The Accumulation of Capital(1956), Economic Philosophy(1963), Introduction to Modern Economics (1973) Famous Quotation: “It is the business of economists, not to tell us what to do, but show why what we are doing anyway is in accord with proper principles.” Learn more about Joan Robinson at ClassZone.com 212 Chapter 7 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. product differentiation nonprice competition b. focus group market share c. oligopoly start-up costs 2. How is monopolistic competition similar to perfect competition and how is it similar to monopoly? 3. Describe some of the techniques sellers use to differentiate their products. 4. Why are standardized products sometimes found in oligopoly but not in monopolistic competition? 5. Is it easier for a new firm to enter the market under monopolistic competition or oligopoly? Why? Monopol
istic Competition Oligopoly 6. Using Your Notes How does the number of sellers compare in monopolistic competition and oligopoly? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com. Contrasting Economic Information What makes the market for wheat different from the markets for products made from wheat, such as bread, cereal, and pasta? 8. Applying Economic Concepts In 2005, a major U.S. automaker announced a new discount plan for its cars for the month of June. It offered consumers the same price that its employees paid for new cars. When the automaker announced in early July that it was extending the plan for another month, the other two major U.S. automakers announced similar plans. What market structure is exhibited in this story and what specific characteristics of that market structure does it demonstrate? 9. Analyzing Effects Blue jeans are produced under monopolistic competition, so their prices are higher than if they were produced under perfect competition. Do the positive effects for consumers of blue jeans justify the higher prices? Why or why not? 10. Challenge Why do manufacturers of athletic shoes spend money to sign up professional athletes to wear and promote their shoes rather than differentiating their products strictly on the basis of physical characteristics such as design and comfort? Perfect competition or monopoly? The Impact of Market Structure Each of the four market structures carries different consequences for businesses and consumers. Imagine what would happen if there were only one type of market structure. Use Figure 7.5 on page 211 as a guide as you do this exercise. a. What would your town look like if every market was perfectly competitive? What would happen to your consumer choices? b. What would happen if every market was ruled by monopolistic competition? c. What would the town look like if oligopolies controlled every market? d. What if every market in your town was ruled by a monopoly? How could you tell the difference between situation A and D? Challenge Now think about what your town actually looks like. What types of market structures are most prevalent? Are you satisfied with the mix of market structures, or do you think some markets would be better served by different structures? Market Structures 213 S E C T I O N 4 Regulation and Deregulation Today TA K I N G N O T E S In Section 4, you will regulation, p. 214 • explain how government acts antitrust legislation, p. 214 to prevent monopolies • analyze the effects of anti- competitive business practices • describe how government acts to protect consumers
• discuss why some industries have been deregulated and the results of that deregulation trust, p. 214 merger, p. 214 price fixing, p. 216 market allocation, p. 216 predatory pricing, p. 216 cease and desist order, p. 217 public disclosure, p. 217 deregulation, p. 218 As you read Section 4, complete a hierarchy diagram to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Regulation and Deregulation Promoting Competition details Promoting Competition KEY CONCEPT S The forces of the marketplace generally keep businesses competitive with one another and attentive to consumer welfare. But sometimes the government uses regulation— controlling business behavior through a set of rules or laws—to promote competition and protect consumers. The most important laws that promote competition are collectively called antitrust legislation, laws that define monopolies and give government the power to control them and break them up. A trust is a group of firms combined for the purpose of reducing competition in an industry. (A trust is similar to a cartel, which you learned about in Section 2.) To keep trusts from forming, the government regulates business mergers. A merger is when one company combines with or purchases another to form a single firm. Origins of Antitrust Legislation During the late 1800s, a few large trusts, such as Standard Oil, dominated the oil, steel, and railroad industries in the United States. The U.S. government became concerned that these combinations would use their power to control prices and output. As a result, in 1890, the government passed the Sherman Standard Oil Company This cartoon dramatizes how Standard Oil controlled the oil industry. QUICK REFERENCE Regulation is a set of rules or laws designed to control business behavior. Antitrust legislation defines monopolies and gives government the power to control them. A trust is a group of firms combined in order to reduce competition in an industry. A merger is the joining of two firms to form a single firm. 214 Chapter 7 Antitrust Act. This gave government the power to control monopolies and to regulate business practices that might reduce competition. Over time, other laws strengthened the government’s ability to regulate business and to encourage competition. To understand why government officials pushed for antitrust laws, consider one of the trusts that developed in the late 1800s—the Standard Oil Company. By merging with other companies and eliminating competitors, Standard Oil gained control of about 90 percent of the U.S. oil industry. Such a huge holding, government officials contended
, gave Standard Oil the ability to set production levels and prices. In 1911, the U.S. government won a court case under the Sherman Antitrust Act that required the breakup of the trust. In order to increase competition, Standard Oil was forced to relinquish control of 33 companies that had once been part of the trust. Antitrust Legislation Today At various times, the U.S. government has used antitrust legislation to break up large companies that attempt to maintain their market power through restraint of competition. The government might allow a large dominant firm to remain intact because it is the most efficient producer. Or it might order that the company change its business practices to allow other firms to compete more easily. The responsibility for enforcing antitrust legislation is shared by the Federal Trade Commission (FTC) and the Department of Justice. A major focus of their work is the assessment of mergers. The government tends to support mergers that might benefit consumers. For example, larger firms are often able to operate more efficiently, and lower operating costs may lead to lower prices for consumers. On the other hand, the government tends to block mergers that lead to greater market concentration in the hands of a few firms. A merger that makes it more difficult for new firms to enter a market will also be looked upon with concern. To evaluate a potential merger, the government looks at how a particular market is defined. A company that is proposing a merger would try to define its market as broadly as possible, in order to make its control of the market seem smaller. For example, a soft drink producer might claim that its market competition includes all beverages, such as water, tea, coffee, and juice. To determine whether the merger will increase the concentration in the market and decrease competition, the government considers the market share of the firms before and after the proposed merger. Government regulators also look at whether the merger allows a firm to eliminate possible competitors. If this analysis shows that a merger will reduce competition and more than likely lead to higher prices for consumers, the regulators will deny the companies’ effort to merge. The Federal Trade Commission (FTC) In 2004, Deborah Platt Majoras became head of the FTC, an agency that enforces antitrust laws. AP P LI CATION Drawing Conclusions A. Which of these mergers would the government be more likely to approve and why: two airlines that serve different cities or two banks in a small town? Market Structures 215 Ensuring a Level Playing Field KEY CONCEPT S In addition to evaluating mergers, the
government also tries to make sure that businesses do not engage in practices that would reduce competition. As you have learned, competition enables the market economy to work effectively. When businesses take steps that counteract the effects of competition, prices go up and supplies go down. In the United States, laws prohibit most of these practices. The FTC and the Department of Justice enforce these laws. Prohibiting Unfair Business Practices Businesses that seek to counteract market forces can use a variety of methods. One is price fixing, which occurs when businesses work together to set the prices of competing products. A related technique is when competing businesses agree to restrict their output, thereby driving up prices. For example, in the mid-1990s the five major recorded music distributors began enforcing a “minimum advertised price” for compact discs sold in the United States. As a result, CD prices remained artificially high. The FTC estimated that consumers paid about $480 million more for CDs than they would have if prices had been established by market forces. In 2000 the FTC reached an agreement with the distributors to end this anticompetitive practice. Another way businesses seek to avoid competition is by market allocation, which occurs when competing businesses negotiate to divide up a market. By staying out of each other’s territory, the businesses develop limited monopoly power in their own territory, allowing them to charge higher prices. For example, in the early 1990s agribusiness conglomerate Archer Daniels Midland (ADM) conspired with companies in Japan and Korea to divide the worldwide market for lysine, an additive used in livestock feeds. Around the same time, ADM also conspired with European companies to divide the worldwide market for citric acid, an additive used in soft drinks, canned foods, and other consumer products. Both of these illicit agreements also included price fixing. In 1996, the Department of Justice charged ADM with antitrust violations in both the lysine and citric acid markets. ADM pleaded guilty and paid a $100 million fine. Occasionally, businesses use anticompetitive methods to drive other firms out of a market. One technique used by cartels or large producers is predatory pricing, setting prices below cost so that smaller producers cannot afford to participate in a market. Predatory pricing can be difficult to distinguish from competitive pricing. Larger businesses are usually able to offer lower prices because they have economies of scale unavailable to smaller firms. APPLICATION Applying Economic Concepts B. If you owned an ice cream store, could you negotiate with other ice cream store owners to set a
standard price for a scoop of ice cream? Why or why not? QUICK REFERENCE Price fixing occurs when businesses agree to set prices for competing products. Market allocation occurs when competing businesses divide a market amongst themselves. Predatory pricing occurs when businesses set prices below cost for a time to drive competitors out of a market. Find an update about unfair business practices at ClassZone.com 216 Chapter 7 Protecting Consumers KEY C ONCEPT S When the government becomes aware that a firm is engaged in behavior that is unfair to competitors or consumers, it may issue a cease and desist order, a ruling that requires a firm to stop an unfair business practice. The government also enforces a policy of public disclosure, which requires businesses to reveal product information to consumers. This protects consumers and promotes competition by giving consumers the information they need to make informed buying decisions. Consumer Protection Agencies Besides enforcing laws that ensure competitive markets, the government protects consumers by regulating other aspects of business. Figure 7.6 shows some of the most important federal agencies that protect consumers. The Federal Trade Commission has primary responsibility for promoting competition and preventing unfair business practices. The Federal Communications Commission and Securities and Exchange Commission regulate specific industries. The Food and Drug Administration, Environmental Protection Agency, and Consumer Product Safety Commission protect consumers by regulating multiple industries to ensure the safety and quality of specific products and to protect consumer health. QUICK REFERENCE A cease and desist order requires a firm to stop an unfair business practice. Public disclosure is a policy that requires businesses to reveal product information. F I G U R E 7. 6 Federal Consumer Protection Agencies Agency Created Purpose Food and Drug Administration (FDA) 1906 Protects consumers from unsafe foods, drugs, or cosmetics; requires truth in labeling of these products Federal Trade Commission (FTC) 1914 Federal Communications Commission (FCC) Securities and Exchange Commission (SEC) Environmental Protection Agency (EPA) Consumer Product Safety Commission (CPSC) 1934 1934 1970 1972 Enforces antitrust laws and monitors unfair business practices, including deceptive advertising Regulates the communications industry, including radio, television, cable, and telephone services Regulates the market for stocks and bonds to protect investors Protects human health by enforcing environmental laws regarding pollution and hazardous materials Sets safety standards for thousands of types of consumer products; issues recalls for unsafe products ANALYZE TABLES 1. What’s the difference between the FTC and the SEC? 2. Pick one agency, note the year it was created, and explain what might have led to its creation. AP P
LI CATION Making Inferences C. Why do you think the government has decided to set up agencies to protect consumers from unsafe products? Market Structures 217 QUICK REFERENCE Deregulation reduces or removes government control of business. Deregulating Industries KEY CONCEPT S Much government regulation in the 20th century focused on controlling industries that provided important public services. For example, in the 1930s, in response to bank closings and other problems during the Great Depression, the U.S. Congress passed many laws for oversight of the financial services industry. In the 1970s, a trend toward deregulation began. Deregulation involves actions taken to reduce or to remove government oversight and control of business. Deregulation has benefits and drawbacks. Deregulation generally results in lower prices for consumers because the markets become more competitive. Firms in industries with regulated prices have little or no incentive to reduce costs. But deregulation may lead to fewer protections for consumers. Deregulating the Airlines The Airline Deregulation Act of 1978 removed all government control of airline routes and rates. Only safety regulations remained in place. Prior to 1978, there was limited competition, and airlines differentiated based on service rather than price. As a result of deregulation, the industry expanded as many new carriers entered the market. Increased competition led to greater efficiency. Economists estimate that prices fell by 10 to 18 percent, falling most sharply on heavily traveled routes where there was the greatest amount of competition. More people than ever before, lured by lower prices, chose to travel by plane. However, the quality of service declined as airlines cut back on food and other in-flight amenities to reduce costs. In addition, many travelers encountered crowded airports as a result of the increase in air travel. It took time for local governments to expand facilities to accommodate the increase in traffic. The financial pressures led to a large number of bankruptcies among the airline companies. Airline employees faced increased layoffs, lower wages, and loss of pensions. APPLICATION Analyzing Causes C. Why did deregulation of the airline industry lead to lower prices for many consumers? 218 Chapter 7 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. trust b. price fixing c. regulation merger predatory pricing deregulation 2. What is the main purpose of antitrust legislation? 3. How does market allocation lead to reduced competition? 4. When would the government issue a cease and
desist order? 5. How do public disclosure requirements protect consumers? 6. Using Your Notes Why is it important for the government to evaluate and approve mergers? Refer to your completed hierarchy diagram. Regulation and Deregulation Promoting Competition details Use the Graphic Organizer at Interactive Review @ ClassZone.com. Analyzing Causes and Effects In 2005, the FTC approved the merger of The Gillette Company with Procter & Gamble. Experts who reviewed the merger said it made sense that it was approved because the two companies had few products in the same market categories. In order to satisfy the government, the companies had to sell only two of their brands to other companies. What factors that affect mergers are illustrated in this story? 8. Applying Economic Concepts In the early 2000s, a new form of marketing emerged called word-of-mouth marketing or buzz marketing. Companies hired ordinary people to talk about the benefits of their products to others. Marketing industry lawyers warned their clients that it was important that the hired spokespeople reveal that they were paid for their endorsements. What are the lawyers concerned about? Use the concepts from this section to formulate your answer. 9. Challenge The Telecommunications Act of 1996 included provisions to deregulate the cable television industry. In 2003, consumer organizations complained that cable rates had increased by 45 percent since the law was passed. Only 5 percent of American homes had a choice of more than one cable provider in 2003. Those homes paid about 17 percent less than those with no choice of cable provider. How effective had deregulation been in the cable industry by 2003? Cite evidence to support your answer. Identifying Regulatory Agencies Several federal agencies provide protection for consumers. Many of them are listed in Figure 7.6 on page 217. Decide which agency or agencies from Figure 7.6 would best protect consumers in each of the situations below. a. Children’s necklaces sold over the Internet are found to contain high levels of lead. Consumers are concerned about the chance of lead poisoning. b. Advertising for a skin cream claims that it will eliminate acne problems. Consumers find that the product does not live up to its claim and in fact seems to irritate people’s faces and cause rashes. c. Some apple farmers use a pesticide on their trees that causes illness. More and more of the pesticide has been found in groundwater supplies. Challenge Find out about a government regulatory agency not listed in Figure 7.6. Discuss the agency’s purpose with your class. Market Structures 219
Case Study Find an update on this Case Study at ClassZone.com Competition in Gadgets and Gizmos Background Cellular phones are a highly successful telecommunications product. Since they first appeared on the market in the 1980s, cell phone sales have grown steadily. Now, billions of people around the world own cell phones. As the global market becomes saturated with cell phones, sales growth will slow. To counteract this, cell phone producers rely on product differentiation to increase sales. New gadgets and gizmos aim to make the cell phone both irresistible and indispensable. A director of business development at one cell phone maker summed up his strategy this way: “We are trying to drive the cell phone in[to] every aspect of your life.” What’s the issue? What affects your selection of a cell phone? Study these sources to discover how producers use product differentiation to compete for your business. Nokia Hopes to Attract Consumers with Mobile-TV Web-browsing, picture-messaging, videos, and now TV Nokia, the world’s largest handset-maker, has just released the results of a mobile-TV trial in Helsinki which found that 41% of participants were willing to pay for the service, and thought is the European Union a monthly fee of 10 [ currency, the euro] ($12.50) was reasonable. As revenue from voice calls has stopped growing in developed markets, the industry has been searching for new avenues for growth. In recent years, it has championed mobile web-browsing, picture-messaging and videotelephony.... But... consumers have not taken to these things in large numbers.... Ah, but mobile TV is different from all those other services... because there is no need to educate the consumer. “Everyone gets it if you say ‘mobile TV’,” says Richard Sharp of Nokia. Source: “Anyone for Telly? ” The Economist, September 10, 2005 Thinking Economically What caused Nokia to develop mobile-TV? Explain, using evidence from the article. A. Magazine Article Nokia Corporation, a maker of phone handsets, developed several add-ons to boost sales. This article describes one of Nokia’s plans. 220 Chapter 7 B. Cartoon This cartoon makes light of the dozens of features packed into most cellular phones. Source: www.CartoonStock.com Thinking Economically Why do cellular phone makers include so many features in their phones? Text not available for
electronic use. Please refer to the text in the textbook. C. Online Press Release Gartner, Inc. provides research and analysis on the information technology industry. This press release presents its projections on mobile phone sales. Thinking Economically Are manufacturers more likely to offer differentiated products in new markets or in those already established? Explain your answer. THINKING ECONOMICALLY Synthesizing 1. Compare the product described in document A and the one illustrated in B. Are cell phones likely to become more or less complex? Explain why or why not. 2. Which of the four market structures best fits the market for cellular phones? Use evidence from documents A and C to explain your answer. 3. In documents A and C, compare the role that market research plays in the development of new products. Use evidence from the documents. Market Structures 221 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. antitrust legislation barrier to entry cartel cease and desist order deregulation economies of scale geographic monopoly market structure merger monopolistic competition monopoly natural monopoly nonprice competition oligopoly patent perfect competition price fixing price taker standardized product start-up costs 1 is an economic model of the nature and degree of competition among businesses in the same industry. In 2 there are many buyers and sellers of standardized products. In a 3 there is a single seller of a product with no close substitutes. The local water company is an example of a 4 because 5 make it most efficient for a single company to provide the service. A 6 is a group of sellers that acts together to set prices and limit output. A 7 is anything that makes it difficult for a business to enter a market. In 8 there are many buyers and sellers of similar but differentiated products. In such a market the sellers engage in 9. In 10 there are only a few sellers for many buyers. It is hard for new firms to enter such a market due to high 11. Sellers in such a market engage in 12 when they all agree to charge the same price for their products. 13 gives the government the power to control monopolies and to promote competition. 222 Chapter 7 CHAPTER 7 Assessment What Is Perfect Competition? (pp. 192–197) 1. What determines the difference between one market structure and another? 2.
Why is perfect competition not found in real markets? The Impact of Monopoly (pp. 198–205) 3. How does a monopoly control the price of its product? 4. Name three ways in which a monopoly differs from perfect competition. Other Market Structures (pp. 206–213) 5. Why is product differentiation necessary for monopolistic competition? 6. Why are firms in an oligopoly less independent in setting prices than firms in monopolistic competition? Regulation and Deregulation Today (pp. 214–221) 7. What factors does the government consider in deciding whether to approve a merger? 8. Why do economists generally favor deregulation of most industries? A P P LY Look at the table below showing retail sales. 9. Which retail market is the least concentrated? Which market is most concentrated? 10. Which markets are closer to monopolistic competition and which are closer to oligopoly? FIGURE 7.7 SALES CONCENTR ATION IN RE TA IL TR ADE Retail Market Percent of Total Sales by the Four Largest Firms Furniture Clothing Supermarkets Music Athletic footwear Books Discount department stores Source: U.S. Census Bureau, 2002 data 8 29 33 58 71 77 95 11. Applying Economic Concepts In 2004, a new trend started in the marketing of music CDs. A variety of retailers, from coffee shop and restaurant chains to large discount stores, began negotiating marketing deals that allowed them to sell a particular recording artist’s CDs exclusively for a period of time. a. What part of monopolistic competition does this trend reinforce: the monopolistic aspect or the competition aspect? b. How is this trend likely to affect prices for these Compete for Buyers CDs? Give reasons why. 12. Analyzing Causes and Effects After deregulation of the airline industry, many of the largest U.S. airlines struggled financially. These airlines then increased their business in the international market in order to boost their profits. What effect of deregulation caused the airlines to make this move? 13. Making Inferences The company that invented the first xerographic photocopier initially enjoyed 70 percent profit margins and a 95 percent market share. Several years later a Japanese camera company invented another way to make photocopiers. Over time, the original company’s market share fell to 13 percent. What specific kind of market structure is illustrated by this example? When a company invents a new product or process, what concerns might they have, if they studied this example? 14. Drawing Conclusions An herbal
supplement company claimed that its product would cure serious diseases and promote weight loss. In 2005, the Federal Trade Commission (FTC) required the company to stop making those claims. Why did the FTC rather than the Food and Drug Administration (FDA) handle this case? 15. Challenge Why might a local electric company be in favor of regulations that would allow it to remain a natural monopoly? Why might it oppose regulations that would require monitoring the pollution from its generating plants? Step 1. Choose a partner. Imagine that together you run a company that produces flat-screen televisions under monopolistic competition. Use the criteria in this table to decide how to differentiate your product. Product and Marketing Considerations • Physical characteristics • Where it will be sold • Packaging or labeling • Service • Advertising and promotion • Price (from $500 to $1,500) Step 2. Create a poster that outlines your product and marketing decisions. Include a sketch of one of your televisions along with the price. Step 3. Display all the posters in the classroom. Allow all students to buy a television from the company of their choice. Tally the results and see how many buyers each company attracted. Step 4. Merge with two or three other companies to form a larger company. There should now be only three or four producers. Discuss how this new situation might affect your marketing decisions. Step 5. As a class, discuss what would happen if the three or four firms became a cartel and acted like a monopoly. Challenge Which of these scenarios would you prefer as a producer? Which would you prefer as a consumer? Market Structures 223 Microeconomics U n i t 3 Partners in the American Economy Types of Businesses Businesses are organized in different ways. The organization that suits a small business, such as this florist, may not be appropriate for a large manufacturer. 224 CHAPTER 8 SECTION 1 Sole Proprietorships SECTION 2 Forms of Partnerships SECTION 3 Corporations, Mergers, and Multinationals SECTION 4 Franchises, Co-ops, and Nonprofits CASE STUDY Apple: The Evolution of One Company Types of Business Organizations producer is a maker of goods or provider of services Most of the producers in a market economy are business organizations, commercial or industrial enterprises and the people who work in them. The purpose of most business organizations is to earn a profit AT T E R S Do you have a part-time job after school or on weekends? Perhaps you work behind the counter at the local flower shop or as a server at the juice
bar downtown. Or perhaps you work as a stocker at one of the large clothing stores at the shopping mall. These businesses are of varying sizes and are organized differently. The American free enterprise system allows producers to choose the kind of business organization that best suits their purpose. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on Apple Inc. (See Case Study, pp. 252–253.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How did Apple Inc., which began in a garage, grow into a major multinational corporation? See the Case Study on pages 252–253. Types of Business Organizations 225 S E C T I O N 1 Sole Proprietorships TA K I N G N O T E S In Section 1, you will business organization, p. 226 • identify the characteristics of sole proprietorship, p. 226 limited life, p. 228 unlimited liability, p. 228 sole proprietorships • describe how sole proprietorships are established • compare the economic advantages and economic disadvantages of sole proprietorships As you read Section 1, complete a chart showing the advantages and disadvantages of sole proprietorships. Use the Graphic Organizer at Interactive Review @ ClassZone.com Sole Proprietorships Advantages Disadvantages The Characteristics of Sole Proprietorships KEY CONCEPT S Every business begins with a person who has an idea about how to earn money and the drive to follow through on the idea and to create a business organization. A business organization is an enterprise that produces goods or provides services. Most of the goods and services available in a market economy come from business organizations. The purpose of most business organizations is to earn a profit. They achieve this purpose by producing the goods and services that best meet consumers’ wants and needs. In the course of meeting consumer demand, business organizations provide jobs and income that can be used for spending and saving. Business organizations also pay taxes that help finance government services. The most common type of business organization in the United States is the sole proprietorship, a business owned and managed by a single person. Sole proprietorships include everything from mom-and-pop grocery stores to barbershops to computer repair businesses. They account for more than 70 percent of all businesses in the United States. However, they generate less than 5 percent of all sales by American businesses. Sole Proprietors
hips Beauty salons are frequently operated by one owner. QUICK REFERENCE A business organization is an enterprise that produces goods or provides services, usually in order to make a profit. A sole proprietorship is a business organization owned and controlled by one person. 226 Chapter 8 E XAMPLE Bart’s Cosmic Comics To understand how sole proprietorships are set up and run, let’s look at the example of Bart’s Cosmic Comics. Bart started collecting comic books in grade school. Over the years, he amassed a huge collection of comics as well as other related items—lunch boxes, action figures, and so on. At the same time, he learned a lot about the comic book business. So, few of his friends expressed surprise when Bart announced that he wanted to open a business selling comic books and related merchandise. Raising Funds Bart needed money to rent and renovate the space he found downtown and to buy new and used comics to stock the store. A hefty withdrawal from his savings account got him started, but he needed to borrow to get the job finished. He tried to get a loan from a local bank. However, because he was not yet an established business owner, bank officers were reluctant to approve the loan. Finally, he turned to his family and friends, who together lent him $15,000. Preparing to Open After raising the necessary funds, Bart completed the few legal steps required to open his business. These included obtaining a business license and a site permit, a document stating that the local government allowed him to use the space he was renting for business. He also registered the name he had chosen for his business—Bart’s Cosmic Comics. Initial Difficulties At first, business was slow. Bart worried that the store would fail and he would be stuck with no income and no way to repay the loans. He thought the safest course of action might be to hang on to what cash he had so he could keep the store open for as long as possible. After much consideration, however, he decided to take another risk, spending $1,000 on advertisements in local newspapers. He also ran several in-store promotions. His business began to take off. Success Within 18 months, Bart had paid back his loans and was earning a profit. Shortly after, he decided to expand his inventory to include T-shirts and posters and to hire an assistant to help run the store. This time when he asked the bank for a loan to pay for the expansion, bank
officers were ready to approve the financing. Bart’s success indicated that giving him a loan would be a good business decision. AP P LI CATION Applying Economic Concepts A. Identify two or three examples of businesses you might want to establish as sole proprietorships. Find an update on sole proprietorships at ClassZone.com Types of Business Organizations 227 QUICK REFERENCE Limited life is a situation where a business closes if the owner dies, retires, or leaves for some other reason. Unlimited liability means that a business owner is responsible for all the business’s losses and debts. Sole Proprietorships: Advantages and Disadvantages KEY CONCEPT S The sole proprietorship has certain advantages and disadvantages that set it apart from other kinds of business structures. For example, sole proprietorships are not governed by as many regulations as other types of businesses. Also, sole proprietorships have limited life, a situation in which a business ceases to exist if the owner dies, retires, or leaves the business for some other reason. Finally, sole proprietors have unlimited liability, a situation in which a business owner is responsible for all the losses, debts, and other claims against the business. ADVANTAGES Sole Proprietorships There is a reason that sole proprietorships are by far the most common type of business structure: they have several significant advantages. Easy to Open or Close Bart’s start-up requirements were typical: funding, a license, a site permit, and a legally registered name. If Bart wanted to get out of the business, he would find that process easy as well. As long as he has settled all his bills, Bart may close the business when he sees fit. Few Regulations Compared with other business organizations, sole proprietorships are lightly regulated. Bart, for example, must locate his store in an area zoned, or officially set aside, for businesses. He also must treat his employees according to various labor laws. Freedom and Control Bart makes all the decisions and does so quickly without having to check with partners or boards of directors. Having complete control and seeing his ideas come to life gives Bart, like many other sole proprietors, a strong sense of personal satisfaction. In other words, he enjoys being his own boss. Owner Keeps Profits Bart also enjoys the chief economic advantage of the sole proprietorship. Since he is the sole owner of the business, he gets to keep all the profits the business earns. Sole Proprietors
Are Fully Responsible The owner bears full responsibility for running the business but also keeps all of the proﬁ ts. 228 Chapter 8 FIGURE 8.1 SOLE PROPRIETORSHIPS BY REVENUES 1.0% 0.5% 3.6% 5.8% 67.5% 9.2% 12.4% Source: Internal Revenue Service, 2003 data ANALYZE GRAPHS More than $1 million $500,000–$1 million $200,000–$499,999 $100,000–$199,999 $50,000–$99,999 $25,000–$49,999 Less than $25,000 The majority of sole proprietorships do not make a lot of money. In fact, almost 70 percent of sole proprietorships make less than $25,000 in sales during the year. Such small businesses are usually run part time out of the owners’ homes. 1. About what percentage of sole proprietorships make less than $50,000 in annual sales? 2. Make a generalization about sole proprietorships based on information in the graph. DIS ADVANTAGES Sole Proprietorships Bart’s story hints at some of the disadvantages of sole proprietorships as well. Limited Funds Especially at start-up, Bart had very limited funds. This disadvantage is one of the key reasons that sole proprietorships are far more likely to fail than other types of business organizations. Until he had established his business, Bart had trouble securing a bank loan. Without monetary reserves to fall back on, he found it a struggle to stay in business. Even when the business became successful, Bart felt that the lack of funds hurt him. He worried that he would not be able to attract and keep good workers because his limited funds meant he could not pay competitive wages or offer benefits such as health insurance. Limited Life Bart found that some of the advantages of the sole proprietorship may also prove to be disadvantages. He appreciated the ease with which you can set up or close a sole proprietorship. However, this means that sole proprietorships have limited life. If he leaves the business, Bart’s Cosmic Comics ceases to exist. Unlimited Liability Bart enjoys having total responsibility for running the business, even though that means that he works long hours. Having total responsibility for the business produces perhaps the greatest disadvantage of a sole proprietorship—unlimited liability. Bart is legally responsible for all the financial aspects of
the business. If Bart’s Cosmic Comics fails, he must still pay all its debts, even without income from the business. If necessary, he may have to sell property and use his personal savings to pay off debts. Sole proprietors, then, may lose their homes, cars, or personal savings if their businesses fail. AP P LI CATION Analyzing Cause and Effect B. Why do you think that sole proprietorships are the most common form of business organization in the United States? Types of Business Organizations 229 ECO N O M I C S PAC ES E T T E R Mary Kay Ash: Going It Alone Do you have what it takes to “go it alone” as an entrepreneur? See how many of these questions you can answer with a “yes.” • Are you willing to take risks? • Can you live with uncertainty? • Are you self-confident? • Are you self-directed, able to set and reach goals for yourself? • Are you optimistic, energetic, and action-oriented? Like other entrepreneurs, Mary Kay Ash had all of these qualities. She used them to turn $5,000 in personal savings into Mary Kay Inc., a business that now sells billions of dollars of cosmetics and other merchandise every year. Building a Business While raising three children on her own, Ash built a very successful career in direct sales. In 1963, however, Ash suffered a blow when she lost out on a promotion that was given instead to a man she had trained. Feeling she had been treated unfairly, Ash resolved to create an enterprise that would reward women for their hard work. Later that year, she started a cosmetics company with her son Richard and nine sales people—whom Ash referred to as “beauty consultants.” In 1964, sales exceeded $198,000. By the end of 1965, sales had skyrocketed to more than $800,000. Since its founding, Mary Kay® products have been sold at in-home parties rather than in stores. Mary Kay has always had distinctive programs for recognizing women who reached certain goals. Pink Cadillacs, diamond-studded jewelry, luxury vacations, and other incentives spur the sales representatives to greater and greater efforts. In 1987, Ash assumed the title of chairman emeritus, Mary Kay Ash Mary Kay Ash grew her business into a major corporation. though she remained active in the company until her death in 2001. Her company and its culture continued to flourish. In 2005, over 1.6 million Mary Kay
beauty consultants operated in more than 30 countries worldwide. As the company expanded globally, China became Mary Kay’s largest market outside the United States. APPLICATION Making Inferences C. Why do you think Mary Kay Ash proved so successful in her cosmetics venture? FAST FACTS Mary Kay Ash Title: Founder of Mary Kay Inc. Born: May 12, 1918 Died: November 22, 2001 Major Accomplishment: Creating Mary Kay Inc., a company that offers women unique rewards for business success Sales Milestones: 1965—$800 thousand 1991—$500 million 2005—$2 billion Mary Kay Career Cars: Sales people who have qualified for a pink Cadillac or other Mary Kay career car: more than 100,000 Famous Quotation: “If you think you can, you can. And if you think you can’t, you’re right.” Find an update on Mary Kay Inc. at ClassZone.com 230 Chapter 8 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. business organization sole proprietorship b. limited life unlimited liability 2. What are the main advantages of a sole proprietorship? 3. What are the main disadvantages of a sole proprietorship? 4. Who gets the profits from a sole proprietorship? Who has to pay all the debts? 5. What steps do new sole proprietorships usually need to take before they can open? 6. Using Your Notes Select one of the businesses you identified in Application A on page 227. If you were starting that business, do you think the advantages of a sole proprietorship would outweigh the disadvantages or vice versa? Why? Refer to your completed chart as you formulate your answer. Use the Graphic Organizer at Interactive Review @ ClassZone.com Sole Proprietorships Disadvantages Advantages. Evaluating Economic Decisions Suppose Cosmic Comics becomes very successful, and Bart decides to try opening a second store. What issues should Bart consider? What challenges will he face? 8. Making Inferences and Drawing Conclusions In what ways might limited life be considered an advantage for sole proprietors? 9. Applying Economic Concepts Explain how a sole proprietorship rests on the principles of free enterprise. 10. Writing About Economics Write a brief paragraph explaining what Bart might learn from Mary Kay Ash. 11. Challenge How many “yes” answers did you provide to the questions at the top of page 230? If you had one
or more “no” answers, explain how you would change a sole proprietorship in order to suit your skills and abilities. If you answered “yes” to all of the questions, explain what you would like about running your own business. Business fairs promote new opportunities. Starting Your Own Business Each year, thousands of Americans start businesses as sole proprietorships. Write a Business Plan Choose a business that you might like to start as a sole proprietorship. Use the following questions to develop a plan that shows how the business will make a profit. • How much money will it take to start the business? Detail each expense. • How much money will it take to run the business each month? Detail each expense. • Who will the customers be and how will you attract them? • Once the business is established, how much will it earn each month? Detail each source of income. • How much profit will you earn? Challenge What challenges do you think you would face in making this business a success? Write a paragraph explaining how you would address these challenges. Types of Business Organizations 231 S E C T I O N 2 Forms of Partnerships TA K I N G N O T E S In Section 2, you will partnership, p. 232 • identify the characteristics and general partnership, p. 233 types of partnerships • compare the economic advantages and disadvantages of partnerships limited partnership, p. 233 limited liability partnership, p. 233 As you read Section 2, complete a comparison and contrast chart to show similarities and differences between partnerships and sole proprietorships. Use the Graphic Organizer at Interactive Review @ ClassZone.com Sole Proprietorships One owner Partnerships Two or more owners The Characteristics of Partnerships KEY CONCEPT S In Section 1, you read how Bart set up his business as a sole proprietorship. His sister, Mary, who is a whiz at bookkeeping, began helping him with the accounting tasks. As her role in the business expanded, Bart proposed that they join forces in a partnership. A partnership is a business co-owned by two or more people, or “partners,” who agree on how responsibilities, profits, and losses will be divided. Bart lacks the bookkeeping skills his sister has, and the extra funds she brings could help Cosmic Comics to grow. Forming a partnership might be a good business decision. QUICK REFERENCE A partnership is a business co-owned by two or more partners who agree on how responsibilities, profits, and losses
of that business are divided. Partnerships are found in all kinds of businesses, from construction companies to real estate groups. However, they are especially widespread in the areas of professional and financial services—law firms, accounting firms, doctors’ offices, and investment companies. There are several different types of partnerships—general partnerships, limited partnerships, and limited liability partnerships—but they are all run in the same general way. 232 Chapter 8 QUICK REFERENCE In a general partnership partners share management of the business and each one is liable for all business debts and losses. A limited partnership is one in which at least one partner is not involved in the day-to-day running of business and is liable only for the funds he or she has invested. In a limited liability partnership (LLP), all partners are limited partners and not responsible for the debts and other liabilities of other partners. T YPE 1 General Partnerships The most common type of partnership is the general partnership, a partnership in which partners share responsibility for managing the business and each one is liable for all business debts and losses. As in a sole proprietorship, that liability could put personal savings at risk. The trade-off for sharing the risky side of the business enterprise is sharing the rewards as well. Partners share responsibility, liability, and profits equally, unless there is a partnership agreement that specifies otherwise. This type of partnership is found in almost all areas of business. T YPE 2 Limited Partnerships In a general partnership, each partner is personally liable for the debts of the business, even if another partner caused the debt. There is a way, however, to limit one’s liability in this kind of business organization. This is through a limited partnership, a partnership in which at least one partner is not involved in the day-to-day running of business and is liable only for the funds he or she has invested. All limited partnerships must have at least one general partner who runs the business and is liable for all debts, but there can be any number of limited partners. Limited partners act as part owners of the business, and they share in the profits. This form of partnership allows the general partner or partners to raise funds to run the business through the limited partners. T YPE 3 Limited Liability Partnerships Another kind of partnership is the limited liability partnership (LLP), a partnership in which all partners are limited partners and not responsible for the debts and other liabilities of other partners. If one partner makes a mistake that ends up costing the business a lot of
money, the other partners cannot be held liable. In LLPs, partners’ personal savings are not at risk unless the debts arise from their own mistakes. Not all businesses can register as LLPs. Those that can include medical partnerships, law firms, and accounting firms. These are businesses in which malpractice—improper, negligent, or unprincipled behavior—can be an issue. LLPs are a fairly new form of business organization, and the laws governing them vary from state to state. Partnerships Doctors’ offices are often run as limited liability partnerships. AP P LI CATION Comparing and Contrasting Economic Information A. What are the differences in liability that distinguish general partnerships, limited partnerships, and limited liability partnerships? Types of Business Organizations 233 Partnerships: Advantages and Disadvantages KEY CONCEPT S Some of the economic advantages of partnerships are similar to those of sole proprietorships. Like sole proprietorships, partnerships are easy to set up and dissolve and have few government regulations. Compared with sole proprietorships, however, partners have greater access to funds. Also, possibilities exist for specialization among partners, which can promote efficiency. The disadvantages of partnerships are similar to the disadvantages of sole proprietorships. Like the sole proprietor, at least one of the partners, except in LLPs, faces unlimited liability. Partnerships, too, have limited life. However, partnerships have at least one disadvantage that sole proprietorships avoid. Disagreements among partners can lead to serious problems in running the business. ADVANTAGES Partnerships Bart and Mary realized that if they formed a partnership they would benefit from some of the same advantages that sole proprietorships have, plus some important additional advantages. Easy to Open and Close Partnerships, like sole proprietorships, are easy to start up and dissolve. Ending the partnership would be equally straightforward for Bart and FIGURE 8.2 PARTNERSHIPS BY REVENUES 7.3% 4.7% Find an update on partnerships at ClassZone.com 6.2% 11.0% 8.7% 54.0% More than $1 million $500,000–$1 million $250,000–$499,999 $100,000–$249,999 $50,000–$99,999 $25,000–$49,999 Less than $25,000 8.1% Source: Internal Revenue Service, 2003 data The majority of partnerships are quite small, making less than $25,000 in
sales during a year. However, close to 20 percent of partnerships take in yearly revenues in excess of $250,000. ANALYZE GRAPHS 1. What percentage of partnerships made more than $100,000 in sales? 2. Some 7 percent of partnerships took in more than $1 million in revenues, compared to just 0.5 percent of sole proprietorships. Why do you think partnerships generate more revenues than sole proprietorships? 234 Chapter 8 his sister. As long as they have settled all their bills, Bart and Mary may dissolve the partnership when they see fit. Few Regulations Bart and Mary would not be burdened with a host of government regulations. They would enter into a legal agreement spelling out their rights and responsibilities as partners. Partners are covered under the Uniform Partnership Act (UPA), a law, adopted by most states, that lays out basic partnership rules. Access to Resources Mary would bring additional funds to Cosmic Comics. In addition, partnerships generally make it easier to get bank loans for business purposes. A greater pool of funds also makes it easier for partnerships to attract and keep workers. Joint Decision Making In most partnerships, partners share in the making of business decisions. This may result in better decisions, for each partner brings his or her own particular perspective to the process. The exception is limited partnerships, in which the limited partner does not participate in running the business. Specialization Also, each partner may bring specific skills to the business. For example, Bart brings knowledge of comic books, while Mary, who studied business accounting in college, brings skills in bookkeeping and finance. Having partners focus on their special skills promotes efficiency. DIS ADVANTAGES Partnerships Bart and Mary also considered the disadvantages of partnerships. Unlimited Liability The biggest disadvantage of most partnerships is the same as that of sole proprietorships: unlimited liability. Both Bart and Mary are personally responsible for the full extent of the partnership’s debts and other liabilities. So they risk having to use their personal savings, and even having to sell their property, to cover their business debts. Joint Decision Making Partners benefit by making decisions together. But sometimes disagreements can interfere with running the business. Potential for Conflict As partners, they may encounter a new disadvantage as well. Having more than one decision maker can often lead to better decisions. However, it can also detract from efficiency if there are many partners and each decision requires the approval of all. Further, disagreements among partners can become so severe that they lead to the closing of the business. Limited Life Like sole
proprietorships, partnerships have limited life. When a partner dies, retires, or leaves for some other reason, or if new partners are added, the business as it was originally formed ceases to exist legally. A new partnership arrangement must be established if the enterprise is to continue. AP P LI CATION Applying Economic Concepts B. Consider the businesses you identified in Application A on page 227 of Section 1. Would these businesses work as partnerships? Why or why not? Types of Business Organizations 235 For more information on distinguishing fact from opinion, see the Skillbuilder Handbook, page R27. Distinguishing Fact from Opinion Facts are events, dates, statistics, and statements that can be proved to be true. Facts can be checked for accuracy. Economists use facts to develop opinions, which may be expressed as judgments, beliefs, or theories. By learning to distinguish between facts and opinions, you will be able to think critically about the economic theories, interpretations, and conclusions of others. TIPS FOR ANALYZING TEXT Use the following guidelines to analyze economic information in written works: FIGURE 8. 3 STARTS AND CLOSURES OF SMALL EMPLOYER FIRMS 2000 New Firms 574,300 Firm Closures 542,831 Bankruptcies 35,472 2001 585,140 553,291 40,099 2002 569,750 586,890 38,540 2003 553,500 572,300 35,037 2004 580,990 576,200 34,317 Sources: U.S. Bureau of the Census; Administrative Office of the U.S. Courts; U.S. Department of Labor, Employment and Training Administration. Opinions. Look for words, such as suggest, suggesting, belief, and believe, which often express assertions, claims, and hypotheses. Many Americans have faith that their ideas will bring them wealth or at least a comfortable living. According to the U.S. government, Americans created more than half a million small firms, or businesses, in the United States each year from 2000 to 2005. While prospective entrepreneurs may interpret these figures as a small business bonanza, overall closures of small businesses also exceeded the half-million mark each year during the same period. And in 2002 and 2003, more small firms closed their doors than opened them, suggesting that market conditions for those two years were particularly unfavorable for the prolonged success of small businesses. Yet bankruptcies among small firms declined in 2002 and 2003. Although such data are
likely to be of interest to prospective entrepreneurs, it is limited in nature. Anyone planning to start a business venture would be wise to conduct more extensive research. Facts used by economists are often in the form of statistics, like the ones in this table. Facts include economic data that can be proved. The writer bases this statement on verifiable facts from the table. Judgments, another form of opinion, often use descriptive words such as wise, foolish, sensible, and fortunate, which have an emotional quality. T HINKING ECONOMICALLY Distinguishing Fact from Opinion 1. What facts, if any, does the author use to support the first sentence in the paragraph? 2. Using information from the table and article, write one statement of fact and one statement of opinion. As a class, share your statements and discuss. 236 Chapter 8 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. partnership b. limited partnership general partnership limited liability partnership 2. What are the main advantages of a partnership? 3. What are the main disadvantages of a partnership? 4. In what ways do the increased resources of a partnership help a business? 5. What determines how partners will divide responsibilities, profits, and debts? 6. Using Your Notes Which type of partnership is most like a sole proprietorship? Explain your answer with specific characteristics. Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com Sole Proprietorships One owner Partnerships Two or more owners. Applying Economic Concepts If you were looking to start a business as a partnership, what traits would you look for in potential partners? Draw up a list of five traits and give a brief explanation for each. Be sure to take the advantages and disadvantages of partnerships into consideration. 8. Comparing and Contrasting Economic Information Briefly explore the differences in potential for job satisfaction between sole proprietorships and partnerships. One size does not fit all—try to determine which of these two business organizations would suit you best. 9. Writing About Economics American business leader John D. Rockefeller said, “A friendship founded on business is a good deal better than a business founded on friendship.” What do you think he had in mind? Write a brief paragraph agreeing or disagreeing, with reference to partnerships. 10. Challenge Do you think that major retail or manufacturing businesses would work as partnerships? Why or why not? Types of Partners
hips The different types of partnerships suit different types of businesses. Identify Partnerships Identify the type of partnership represented in each description. 1. Doctors choose this type of partnership because it protects them from malpractice suits brought against other partners. 2. The only role that George plays in the partnership is to collect profits or bear losses based on the amount of funds he contributed. 3. Stephen and Mike start a consulting service to help businesses manage their trademarks and patents. They are the only partners, sharing equally in the work, profits, and losses. 4. Rosa and Serena carefully review expansion plans after new partners provide extra funds. However, they know that they remain fully liable if their decisions are not sound. Challenge Write a description of three different business partnerships without naming them. Exchange your descriptions with a classmate and identify each other’s partnerships. Types of Business Organizations 237 S E C T I O N 3 Corporations, Mergers, and Multinationals TA K I N G N O T E S In Section 3, you will • identify the characteristics of corporations • compare the advantages and disadvantages of corporations • describe how corporations consolidate to form larger business combinations • explain the role of multinational corporations in the world economy corporation, p. 238 stock, p. 238 dividend, p. 238 public company, p. 238 private company, p. 238 bond, p. 240 limited liability, p. 240 unlimited life, p. 240 horizontal merger, p. 243 vertical merger, p. 243 conglomerate, p. 243 multinational corporation, p. 243 As you read Section 3, complete a cluster diagram that categorizes information about corporations. Use the Graphic Organizer at Interactive Review @ ClassZone.com Characteristics Advantages Corporations Characteristics of Corporations KEY CONCEPT S Corporations are the third main kind of business organization. A corporation is a business owned by individuals, called shareholders or stockholders. The shareholders own the rights to the company’s profits, but they face limited liability for the company’s debts and losses. These individuals acquire ownership rights through the purchase of stock, or shares of ownership in the corporation. For example, suppose a large company sells a million shares in the form of stock. If you bought 10,000 shares, you would own 1 percent of the company. If the company runs into trouble, you would not be responsible for any of its debt. Your only risk is that the value of your stock might decline. If the company does well and earns a profit, you might receive a payment
called a dividend, part of the profit that the company pays out to stockholders. A corporation that issues stock that can be freely bought and sold is called a public company. One that retains control over who can buy or sell the stock is called a private company. Corporations make up about 20 percent of the number of businesses in the United States, but they produce most of the country’s goods and services and employ the majority of American workers. EXAMPLE F & S Publishing, Inc. To better understand how corporations operate, let’s look at F & S Publishing, Inc., a successful publishing business. Frank and Shirley, the founders, decided to turn their business into a corporation because they wished to avoid unlimited liability. A corporation, unlike a partnership or sole proprietorship, is a formal, legal entity separate from the individuals who own and run it. The financial liabilities of F & S QUICK REFERENCE A corporation is a business owned by stockholders, who own the rights to the company’s profits but face limited liability for the company’s debts and losses. Stock is a share of ownership in a corporation. A dividend is part of a corporation’s profit that is paid out to stockholders. A public company issues stock that can be publicly traded. A private company controls who can buy or sell its stock. 238 Chapter CO R P O R AT E S T RUC T U R E Stockholders Board of Directors Corporate Ofﬁ cers Vice President Production Vice President Operations Vice President Marketing Vice President Distribution Research & Development Department Personnel Department Advertising Department Warehousing Department Purchasing Department Finance Department Sales Department Delivery Department Employees ANALYZE CHARTS This chart shows the organization of a typical corporation. Smaller corporations may only have stockholders, corporate officers, and employees. Larger corporations may be much more complex. Imagine you own a company that makes a product you like. Draw an organization chart for your corporation. Publishing, Inc., are separate from the personal financial liabilities of Frank, Shirley, and other F & S stockholders. If the business fails, only the assets of F & S itself—the office building, equipment, and company bank accounts—are at risk. Setting up a corporation involves more work and expense than establishing a sole proprietorship or partnership. Frank and Shirley hired a law firm to draw up and file papers requesting permission from the state government to incorporate. The state government agreed to the request and issued a corporate charter. This document named F & S Publishing,
Inc., as the business, stated its address and purpose, and specified how much stock Frank and Shirley could sell. F & S Publishing, Inc., is organized like the majority of corporations. Stockholders—the owners of the corporation—elect a board of directors. The board hires corporate officers, such as the president and the vice-presidents in charge of sales, production, finance, and so on. These officers are responsible for the smooth running of the corporation. In most corporations, the stockholders and the board of directors are not involved in the day-to-day running of the business. F & S Publishing, Inc., however, is a small company, and Frank and Shirley became members of the board of directors as well as managers. Frank and Shirley decided to make their business a public company. They bought enough of the stock themselves so that they would each have a seat on the board of directors. They sold the rest of the stock to raise money to expand the business. AP P LI CATION Applying Economic Concepts A. Frank and Shirley were worried about unlimited liability. How did incorporating protect them from this problem? Types of Business Organizations 239 Corporations: Advantages and Disadvantages KEY CONCEPT S QUICK REFERENCE A bond is a contract issued by a corporation that promises to repay borrowed money, plus interest, on a fixed schedule. Limited liability means that a business owner’s liability for debts and losses of the business is limited. Unlimited life means that a corporation continues to exist even after an owner dies, leaves the business, or transfers his or her ownership. The advantages of corporations often address the major disadvantages of sole proprietorships and partnerships. For example, corporations are more effective than either of the other business structures at raising large amounts of money. The key methods of raising money are the sale of stock and the issuing of bonds. A bond is a contract the corporation issues that promises to repay borrowed money, plus interest, on a fixed schedule. Also, unlike sole proprietorships and most partnerships, corporations provide their owners with limited liability, which means that the business owner’s liability for business debts and losses is limited. Further, corporations have unlimited life—they continue to exist even after a change in ownership. Sole proprietorships and partnerships do not. Most of the disadvantages of corporations are related to their size and organizational complexity. Corporations are costly and time-consuming to start up; they are governed by many more rules and regulations; and, because of the organizational structure, the
owners may have little control over business decisions. Despite these drawbacks, corporations can be efficient and productive business organizations. FIGURE 8.5 CORPORATIONS BY REVENUES 18.2% 23.7% Find an update on corporations at ClassZone.com 11.5% 13.3% 17.2% Source: Internal Revenue Service, 2003 data More than $1 million $500,000–$1 million $250,000–$499,999 $100,000–$249,999 $50,000–$99,999 $25,000–$49,999 Less than $25,000 6.4% 9.7% Most people think of corporations as very large companies with factories and offices that occupy great expanses of land. Actually, more than a third of all corporations in the United States take in less than $100,000 in revenues each year. ANALYZE GRAPHS 1. What percentage of corporations made more than $250,000 in sales? 2. Compare Figure 8.5 with Figure 8.1 on p. 229 and Figure 8.2 on p. 234. According to the graphs, which type of business has the highest percentage of firms that earn over $1 million in revenues each year? 240 Chapter 8 ADVANTAGES Corporations Frank and Shirley had operated F & S as a partnership for several years. They decided to incorporate to gain the advantages of the corporate business structure. Access to Resources Frank and Shirley have ideas to expand their business, but implementing the ideas may require more money than profits from the business will provide. As a corporation, they have better opportunities for obtaining additional money. Besides borrowing from banks, F & S can raise money by selling more stock or by issuing bonds. This greater access to funds leads to greater potential for growth. Professional Managers Frank and Shirley are involved in the running of F & S Publishing, Inc. Frank serves as chief executive officer (CEO), while Shirley is chief operations officer (COO). However, they decided to hire managers with strong backgrounds in finance and sales as company treasurer and vice-president for sales. Having professionals in charge of financial and sales matters will probably lead to higher profits. Limited Liability Because of limited liability, F & S Publishing, Inc., alone is liable for any debts or losses it incurs. Frank, Shirley, and F & S stockholders are liable only for the money they paid for their stock. The board of directors and officers of the corporation, too, are protected from liability
. Source: www.CartoonStock.com Unlimited Life If any of the owners—the stockholders—of F & S dies or decides to end his or her relationship with the company, the business would continue to operate as before. This even applies to Frank and Shirley. If either or both of them move on to another business, F & S Publishing, Inc., can continue without them for as long as it is a viable business. DIS ADVANTAGES Corporations Frank and Shirley discovered some of the disadvantages to incorporating when they first began the process. They learned about other disadvantages of corporations as they ran their business. Start-Up Cost and Effort When they first started, Frank and Shirley set up their business as a partnership. Compared to setting up the partnership, Frank and Shirley found the process of setting up a corporation more time-consuming, difficult, and expensive. The paperwork they had to prepare and file with the state government was extensive, and they had to hire a law firm to help with this task. Heavy Regulation As a public company, F & S Publishing, Inc., must prepare annual reports for the Securities and Exchange Commission (SEC), the government agency Types of Business Organizations 241 F I G U R E 8.6 Business Organizations: Advantages and Disadvantages Type of Organization Sole Proprietorship Partnership Corporation Advantages Disadvantages • Easy to start up, close down • Sole proprietor has satisfaction of running business his or her own way • Few regulations • Sole proprietor keeps all the profits • Easy to start up, close down • Few regulations • Greater access to funds • Partners share in decision making • Partners may bring complementary skills to the business • Greatest access to funds • Business run by professionals • Limited liability • Unlimited life • Limited funds • Limited life • Unlimited liability • Unlimited liability • Shared decision making may create conflict among partners • Limited life • Difficult to start up • More regulations • Double taxation • Owners may have less control of running the business ANALYZE TABLES All three forms of business organizations have distinct advantages and disadvantages. If you were starting a business, which form of business organization would you choose? Why? that oversees the sale of stocks. It also has to prepare and issue quarterly financial reports for stockholders. Further, the company must hold yearly meetings for its stockholders. All of these regulations help ensure that corporations are run for the benefit of the shareholders. Private companies are subject to fewer regulations related to their ownership. Double Taxation Frank and Shirley experience an effect known
as double taxation. As officers of the company, they are well aware of the taxes on profits that the corporation must pay. As stockholders, they know that their dividend income, paid out of the company profits, is also taxed. Some small corporations qualify for S corporation status, a tax status which avoids double taxation. Loss of Control Frank and Shirley, as founders, owners, and directors, expect to have a major voice in deciding the direction that F & S Publishing, Inc., will take. However, they experienced some loss of control when the rest of the board of directors voted against them and brought in a new sales manager. APPLICATION Evaluating Economic Decisions B. F & S was successful as a partnership. What will Frank and Shirley gain by making their company a corporation? 242 Chapter 8 Business Consolidation KEY C ONCEPT S You’ve probably seen news stories about them—business consolidations that merge, or combine, several large companies into one mega-company. These consolidations take place for several possible reasons. These include increasing efficiency, gaining a new identity as a business or losing an old one, keeping rivals out of the marketplace, and diversifying the product line. There are two main kinds of mergers (see Figure 8.7). A horizontal merger describes the joining of companies that offer the same or similar products or services. A vertical merger describes the combining of companies involved in different steps of production or marketing of a product or service. An alternative to the two main types is a conglomerate, which results from a merger of companies that produce unrelated goods or services. Through growth, consolidations, and other means, an enterprise can grow so big that it becomes a multinational corporation, a large corporation with branches in several countries. F I G U R E 8.7 T Y PES O F M E RG E R S Vertical Merger FORESTRY AGRICULTURE PETROCHEMICAL QUICK REFERENCE A horizontal merger is the combining of two or more companies that produce the same product or similar products. A vertical merger is the combining of companies involved in different steps of producing or marketing a product. A conglomerate is a business composed of several companies, each one producing unrelated goods or services. A multinational corporation is a large corporation with branches in several countries. PRODUCTION Horizontal Merger PROCESSING DISTRIBUTION ANALYZE CHARTS What kind of mergers took place in each of the following situations? 1. In 1999, Ford Motor Co. purchased Swedish-based car manufacturer
Volvo. 2. In 1989, Japanese electronics giant Sony purchased Columbia Pictures Entertainment. Use an interactive merger chart at ClassZone.com Types of Business Organizations 243 Mergers An example of a horizontal merger is the one between Reebok and Adidas in 2005. At the time, they were the second- and third-biggest makers of sports shoes. The subtitle of an article about the merger summed up the potential benefits of all mergers: “Adidas-Reebok merger could trim costs for companies and maybe even some dollars for consumers.” The two companies planned to cut production and distribution costs by combining their operations. This, they hoped, would improve their ability to compete against the largest sport-shoe maker, Nike. More efficient production usually leads to lower prices, which would draw consumers away from Nike. An example of a vertical merger took place in the late 1990s during a period when the oil and gas industry was undergoing major consolidations. Shell Oil, which owned more refineries, joined with Texaco, which owned more gas stations. This type of merger is vertical, since companies involved in different steps of production (refining) or distribution (getting gasoline to customers) combined. Conglomerates Another kind of business consolidation, the conglomerate, is formed when two or more companies in different industries come together. In theory, the advantage of this form of consolidation is that, with diversified businesses, the parent company is protected from isolated economic pressures, such as changing demand for a specific product. In practice, it can be difficult to manage companies in unrelated industries. Conglomerates were popular during the 1960s. One conglomerate of the 1960s was Gulf and Western, which included companies in such diverse fields as communications, clothing, mining, and agricultural products. As with many other conglomerates formed in the 1960s, however, Gulf and Western did not produce the desired financial gains. Gulf and Western sold all its companies but the entertainment and publishing endeavors and became known as Viacom. Multinational Corporations When you use Google to do an Internet search, you are using the services of a multinational corporation, a large corporation with branches in several countries. Google’s headquarters are in Mountain View, California, but it has branch offices in many other countries. Coca-Cola, McDonald’s, Nike, and Sony are all examples of multinational, or transnational, corporations. Multinational corporations like Google are a major force in globalization, commerce conducted without regard to national boundaries. Multinational
corporations have many beneficial effects. They provide new jobs, goods, and services around the world and spread technological advances. When such companies open businesses in poorer countries, the jobs and the tax revenues help raise the standard of living. Source: www.CartoonStock.com 244 Chapter General Electric: Multinational Corporation The operations of General Electric (GE), one of the world’s largest multinational corporations, span the globe. While its headquarters is located in the United States, GE has manufacturing and production centers located in countries far and near. To supply these centers, GE purchases raw materials from all over the world. Further, the corporation has sales centers on six of the seven continents. GE is both a multinational and a conglomerate, offering a wide range of services and products. The diagram below offers a view of GE’s six major businesses and the units that make up these businesses. GE owns many companies that you know. For example, GE owns 80 percent of NBC Universal, which is made up of the NBC television network, Universal Pictures, and many related businesses. GE’s Consumer and Industrial unit manufactures such common products as refrigerators, ovens, and light bulbs. But many of GE’s businesses are less well-known because they provide services and products for businesses and governments. FIGURE 8. 8 GENER AL ELEC TRIC General Electric Commercial Finance Consumer Finance Healthcare Industrial Infrastructure NBC Universal • Capital Solutions • Corporate Financial Services • Healthcare Financial Services • Insurance • Real Estate • Healthcare • Healthcare Technologies • Healthcare Bio-Sciences • Private Label Credit Cards • Personal Loans • Sales Finance • MasterCard and Visa Credit Cards • Auto Loans and Leases • Mortgages • Corporate Cards • Debt Consolidation • Home Equity Loans • Credit Insurance • Advanced Materials • Consumer and Industrial • Equipment Services • GE Fanuc Automation • Inspection Technologies • Plastics • Security Sensing • Aviation • Network • Aviation Financial • Film Services • Energy • Energy Financial Services • Oil and Gas • Rail • Water • Television Stations • Entertainment Cable • Television Production • Sports/Olympic Games • Theme Parks CONNECTING ACROSS THE GLOBE 1. Applying Economic Information What characteristics of General Electric define it as “multinational”? 2. Analyzing Charts General Electric operates in a wide range of industries. Name some industries in which it does not participate. Make sure to check your answer against the chart. However, multinational corporations can also create problems. Some build factories that emit harmful waste products in countries
with lax government regulation. Others operate factories where workers toil for long hours in unsafe working conditions. You will learn more about the impact of multinationals on the world economy in Chapter 17. AP P LI CATION Applying Economic Concepts C. Make up an imaginary conglomerate based on three real companies. Types of Business Organizations 245 ECO N O M I C S PAC ES E T T E R Bill Gates: Entrepreneur and Corporate Leader A reporter once asked multibillionaire Bill Gates, founder of Microsoft Corporation, if he thought there was a larger meaning in the universe. Gates joked, “It’s possible … that the universe exists only for me. If so, it’s sure going well for me, I must admit.” From a small beginning, Bill Gates created the world’s largest software company. Microsoft employs more than 60,000 people in more than 100 countries. Microsoft Corporation Gates was always fascinated with computers and software. He developed software for his high school to schedule classes and for his hometown of Seattle to monitor traffic. At Harvard, he and his friend Paul Allen developed the BASIC language for personal computers. In 1975, during his third year, Gates left college to form a business with Allen to supply BASIC programming for an early brand of personal computers. Gates and Allen called their company Micro-soft (later changed to Microsoft). “I think my most important work was the early work,” Gates said in 2005, “conceiving of the idea of the PC and how important that would be, and the role software would play.... ” Microsoft incorporated in 1981. When it struck a deal to provide the operating system for IBM personal computers, it secured its dominance. Microsoft became an international corporation in 1985, when it opened a production facility in Dublin, Ireland. That same year, it released what would become the world’s most popular operating system, Microsoft Windows. Initially, Microsoft focused on corporate computing. With the release of Windows 95, however, it turned to the consumer market. Bill Gates Bill Gates cofounded Microsoft in 1975. It became one of the world’s most successful corporations. Gates led Microsoft as it continued to dom- inate the computer industry. In 1994, Gates established a foundation for charitable giving that quickly became the largest charitable foundation in the world. The foundation focuses on global health and education. In 2006, Gates began shifting away from the day-to-day responsibilities of running Microsoft and toward running the foundation. APPLIC
ATION Categorizing Economic Information D. Create a timeline showing the development of Microsoft from its founding to its status as a major multinational corporation. FAST FACTS Bill Gates Title: Chairman, Microsoft Corporation Born: October 28, 1955, Seattle, Washington Major Accomplishments: Cofounder, Microsoft, 1975; Time Magazine’s Person of the Year, 2005 (for his charitable work) Books: The Road Ahead (1995); Business @ the Speed of Thought (1999) Estimated Personal Fortune: $46.5 billion in 2005 (ranked #1 in the world) Famous Quotation: “I have always loved the competitive forces in this business. That’s what keeps my job one of the most interesting in the world.” Find an update on Bill Gates and Microsoft at ClassZone.com 246 Chapter 8 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these groups. a. stock bond b. public company private company c. merger conglomerate 2. What are the main advantages of a corporation? 3. What are the main disadvantages of a corporation? 4. How do corporations raise money? 5. What is a multinational corporation? 6. Using Your Notes What is the difference between a vertical merger and a horizontal merger? Refer to your completed cluster diagram. Characteristics Advantages Corporations Use the Graphic Organizer at Interactive Review @ ClassZone.com. Analyzing Cause and Effect Review the table below. If the two largest bottled water manufacturers consolidated in a horizontal merger, what might the effect be on competition? Company Annual Sales (in millions of dollars) Percent of Market Nature’s Springs 1,000 Well Water, Inc. Best Taste Empyrean Isles No-Tap Water 600 400 400 200 25 15 10 10 5 8. Writing About Economics In what ways might a vertical merger in the oil industry influence gas prices? 9. Explaining an Economic Concept What are the benefits of combining several companies to form a conglomerate? Name an example of a conglomerate. 10. Challenge So far in this chapter, you have learned about business enterprises that seek profits. In Section 4, you will learn about nonprofit organizations. How do you think the structure of such organizations might differ from the structure of profitseeking organizations? Analyzing Data When companies decide to merge, they must carefully evaluate how to combine their operations. Will This Merger Work? Leviathan Motion Pictures wants to purchase Pipsqueak Computer Games. Leviathan
Pipsqueak Ivana Getrich, age 60 Bob L. Head, age 30 15 business executives Bob and a couple of his buddies 200,000,000 250,000 $5,000,000,000 $250,000,000 Head of Company Board of Directors Publicly Owned Shares Market Capitalization 2008 Sales $1,000,000,000 $10,000,000 Production Studios 4 in California, 1 in New York 1 in Austin Employees 15,000 worldwide 150 in Austin Review the table and imagine what would happen if the companies merge. Write a paragraph describing the challenges and the benefits. Challenge If you were Bob, would you retire after selling Pipsqueak, or would you want to continue running the company? Explain your answer. Types of Business Organizations 247 S E C T I O N 4 Franchises, Co-ops, and Nonprofits TA K I N G N O T E S In Section 4, you will • explain how franchises function • identify the characteristics and purpose of cooperatives • describe the types and purposes of nonprofit organizations franchise, p. 248 franchisee, p. 248 cooperative, p. 250 nonprofit organization, p. 250 As you read Section 4, complete a summary chart with information on specialized organizations. Use the Graphic Organizer at Interactive Review @ ClassZone.com Franchises Co-ops Nonprofits Franchises KEY CONCEPT S QUICK REFERENCE A franchise is a business that licenses the right to sell its products in a particular area. A franchisee is a semiindependent business that buys the right to run a franchise. A franchise is a business made up of semi-independent businesses that all offer the same products or services. Each franchisee, as the individual businesses are known, pays a fee to the parent company in return for the right to sell the company’s products or services in a particular area. Fast-food restaurants are the most common franchised business. However, this kind of business organization is also found in many other industries, including hotels, rental cars, and car service. EXAMPLE An Almost Independent Business The Mango Grove Juice and Nut Bar in the city center provides an illustration of how a franchise works. Tim, who runs the Mango Grove, had worked as assistant manager at a local restaurant for several years. He really wanted to run his own business, but he didn’t think he had the experience or the funds to go it alone. On trips to other cities, he had been impressed by the popularity of the Mango
Grove Juice and Nut Bar, an organic juice and sandwich restaurant. So he looked into becoming a franchisee of that business in his home city World’s Leading Franchises 4. Cendent (Howard Johnson, Avis, etc.) 2. Yum! Brands (KFC, Taco Bell, etc.) Source: International Franchise Association, 2004 data 1. McDonald’s Corporation Franchisees 3. 7-Eleven 5. Subway 30,300 28,200 29,300 24,600 21,000 248 Chapter 8 YO U R EC FR ANC HISES Which franchise would you like to run? Hundreds of different businesses operate as franchises. Fast-food restaurants and coffee bars are among the most common. Which type of franchise would you like to run? Why?? ADVANTAGES Franchises Becoming a franchisee of Mango Grove Juice and Nut Bar appealed to Tim for several reasons. First, he would have a level of independence he did not have in his job at the restaurant. Second, the franchiser, Mango Grove Fruit and Nut Bar, would provide good training in running the business, since his success affected their own. They would also provide proven products—their famous mango smoothie mixes and nut bread for sandwiches—as well as other materials, such as the décor common to all the Mango Grove juice bars, at a relatively low cost. Further, the franchiser would pay for national or regional advertising that would bring in customers. DIS ADVANTAGES Franchises Tim also thought through the disadvantages. He would have to invest most of the money he had saved, with no assurance of success in the business. He would also have to share some of the profits with the franchiser. Further, he would not have control over some aspects of the business. For example, he would have to meet the franchiser’s operating rules, such as buying materials only from the franchiser and limiting the products he offered to those from the franchiser. After considerable thought, Tim decided to apply to become a franchisee. He was accepted, and before long his business became a success. In time, a number of other Mango Grove bars opened in other parts of the city. Since both the franchiser and franchisees had the same incentive—financial reward if the business was successful—they worked well together to make the juice bars succeed. AP P LI CATION Evaluating Economic Decisions A. What advantage does the franchiser have over a business that owns and operates all of its own shops?
Types of Business Organizations 249 Cooperatives and Nonprofits KEY CONCEPT S The primary purpose of most businesses is to earn money for the owners—in other words, to make a profit. But not all businesses exist solely to make a profit. A cooperative is a type of business operated for the shared benefit of the owners, who are also its customers. A nonprofit organization is an institution that acts like a business organization, but its purpose is usually to benefit society, not to make a profit. A Business Organization for Its Members When people who need the same goods or services band together and act as a business, they can offer low prices by reducing or eliminating profit. Such organizations are called cooperatives, or co-ops. There are three basic types of cooperatives: consumer, service, and producer. Consumer Consumer, or purchasing, co-ops can be small organizations, like an organic food cooperative, or they can be giant warehouse clubs. Consumer co-ops require some kind of membership payment, either in the form of labor (keeping the books or packaging orders) or monetary fees. They keep prices low by purchasing goods in large volumes at a discount price. Service Service co-ops are business organizations, such as credit unions, that offer their members a service. Employers often form service cooperatives to reduce the cost of buying health insurance for their employees. Producer Producer cooperatives are mainly owned and operated by the producers of agricultural products. They join together to ensure cheaper, more efficient processing or better marketing of their products. A Purpose Other Than Profit There are several different types of nonprofits. Some, like the American Red Cross, have the purpose of benefiting society. They provide their goods or services for free or for a minimal fee. Other nonprofits, like the American Bar Association, are professional organizations. Such organizations exist to promote the common interests of their members. Business associations, trade associations, labor unions, and museums are all examples of organizations pursuing goals other than profits. The structure of a nonprofit resembles that of a corporation. A nonprofit must receive a government charter, for example, and has unlimited life. Unlike a corporation, however, many nonprofit organizations are not required to pay taxes because they do not generate profits and they serve society. Nonprofits raise most of their money from donations, grants, or membership fees. Some nonprofits sell products or services, but only as a way of raising funds to support their mission. APPLICATION Making Inferences B. The National Association of Home Builders promotes the interests of construction companies. Habitat for Humanity builds homes for
the disadvantaged. Which of these nonprofits is the government more likely to excuse from paying taxes? Why? QUICK REFERENCE A cooperative is a business operated for the shared benefit of the owners, who also are its customers. A nonprofit organization is a business that aims to benefit society, not to make a profit. 250 Chapter 8 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Give an example of each of the following terms. a. franchise b. cooperative c. nonprofit organization 2. What are the main advantages of a franchise? 3. What are the main disadvantages of a franchise? 4. How do consumer and service cooperatives save their members money? 5. What are some purposes of nonprofit organizations? 6. Using Your Notes What are the chief distinctions among franchises, cooperatives, and nonprofits? Refer to your completed summary chart. Franchises Co-ops Nonprofits Use the Graphic Organizer at Interactive Review @ ClassZone.com. Explaining an Economic Concept Explain how franchisees share the risk of the business venture with the franchiser. 8. Making Inferences and Drawing Conclusions How do nonprofits get the money needed to pay the people who work for them and to provide services? 9. Evaluating Economic Decisions You’re shopping for a new camera. You could buy it from a specialty camera store that offers expert advice or from a discount retail store that carries hundreds of other products. Or you could join a camera club that offers a buying cooperative. What are the advantages and disadvantages of each option? 10. Challenge Helping society can be big business. The largest nonprofits generate annual revenues in the billions of dollars. Even small nonprofit organizations can make as much money as many for-profit businesses. Nonprofits employ professional managers, accountants, and marketers, just as any other business would. Should the chief executive officer (CEO) of a nonprofit with $500 million in annual revenue be paid the same salary as the CEO of a for-profit company with the same amount of revenue? Explain your answer. Identifying Business Organizations Franchises, co-ops, and nonprofits have distinctive features. What Kind of Organization? Review the following descriptions of business organizations. Decide what kind of business organization fits each description. Remember that there are three different types of cooperatives. • Several companies in your city join together to get a better deal on the health insurance they offer to their workers. • Dan pays a fee for the right to sell Soft Freeze ice cream. Soft Freeze provides all the

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