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supply. If you compare it to the demand schedule in Panel A of Figure 4.1 on page 92, you will see that the two are remarkably similar. The main difference between them is that for supply, the quantity goes up when the price goes up—rather than down as in the case of demand. All suppliers of products must decide how much to offer for sale at various prices—a decision made according to what is best for the individual seller. What is best depends, in turn, upon the cost of producing the goods or services. The concept of supply, like demand, can be illustrated in the form of a table or a graph. The Supply Schedule The supply schedule is a listing of the various quantities of a particular product supplied at all possible prices in the market. Panel A of Figure 5.1 presents a hypothetical supply schedule for CDs. It shows the quantities of CDs that will be supplied at various prices, other things being equal. The Individual Supply Curve The data presented in the supply schedule can also be illustrated graphically as the upward-sloping line in Panel B of Figure 5.1. To draw it, all we do is transfer each of the price-quantity observations in the schedule over to the graph, and then connect the points to form the curve. The result is a supply curve, a graph showing the various quantities supplied at all possible prices that might prevail in the market at any given time. All normal supply curves have a positive slope that goes up from the lower left-hand corner of the graph to the upper right-hand corner. This shows that if the price goes up, the quantity supplied will go up too. Figure 5.1 Supply of Compact Discs A S UPPLY S CHEDULE B S UPPLY C URVE Price $30 25 20 15 10 5 Quantity supplied 30 25 20 15 10 5 0 Decrease in quantity supplied a S b Increase in quantity supplied 1 2 3 4 Quantity 5 6 7 8 The supply schedule and the supply curve both show the quantity of CDs supplied in the market at every possible price. Note that a change in the quantity supplied appears as a movement along the supply curve. Economic Analysis How does the Law of Supply differ from the Law of Demand? Figure 5.2 Individual and Market Supply Curves The market supply curve shows the quantities supplied by all firms that offer the product for sale in a market. Point a on the market supply curve represents the four CDs that Firm A would supply and the two CDs that Firm B would supply, at a price
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of $15, for a total of six CDs. Economic Analysis Why are the supply curves upward sloping? See StudentWorks™ Plus or glencoe.com. S UPPLY C URVE OF F IRM A S UPPLY C URVE OF F IRM B M ARKET S UPPLY C URVE $30 S $30 S $30 S e c i r P 25 20 15 10 5 0 b’ a’ + e c i r P Add the first supply curve... 1 2 3 5 4 Quantity 6 87 25 20 15 10 5 0 b’’ a’’... to the second supply curve... 1 3 2 Quantity 4 5 = e c i r P 25 20 15 10 5 0 b a... to get the market supply curve. 21 3 54 6 87 Quantity 9 10 11 12 13 market supply curve a graph that shows the various amounts offered by all firms over a range of possible prices quantity supplied amount offered for sale at a given price change in quantity supplied change in amount offered for sale when the price changes While the supply schedule and curve in Figure 5.1 represent the voluntary decisions of a single, hypothetical producer of CDs, we should realize that supply is a very general concept. In fact, you are a supplier whenever you look for a job and offer your services for sale. Your economic product is your labor, and you would probably be willing to supply more labor for a high wage than for a low one. The Market Supply Curve The supply schedule and curve in Figure 5.1 show the information for a single firm. Frequently, however, we are more interested in the market supply curve, the supply curve that shows the quantities offered at various prices by all firms that offer the product for sale in a given market. To obtain the data for the market supply curve, add the number of CDs that individual firms would produce, and then plot them on a separate graph. In Figure 5.2, point a on the market supply curve represents six CDs—four supplied by the first firm and two by the second—that are offered for sale at a price of $15. In the same way, point b on the curve represents a total of nine CDs offered for sale at a price of $20. A Change in Quantity Supplied The quantity supplied is the amount that producers bring to market at any given price. A change in quantity supplied is the change in amount offered for sale in response to a change in
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price. In Figure 5.1, for example, four CDs are supplied when the price is $15. If the price increases to $20, six CDs are supplied. If the price then changes to $25, seven units are supplied. These changes illustrate a change in the quantity supplied, which—like the case of demand—shows as a movement along the supply curve. Note that the change in quantity supplied can be an increase or a decrease, depending on whether more or less of a product is offered. For example, the movement from a to b in Figure 5.1 shows an increase because the number of products offered for sale goes from four to six when CHAPTER 5 Supply 119 change in supply situation where different amounts are offered for sale at all possible prices in the market; shift of the supply curve the price goes up. If the movement along the supply curve had been from point b to point a, there would have been a decrease in quantity supplied because the number of products offered for sale went down. It makes no difference whether we are talking about an individual supply curve or a market supply curve. In either case, a change in quantity supplied takes place whenever a change in price affects the amount of a product offered for sale. In a market economy, producers usually react to changing prices in just this way. While the interaction of supply and demand usually determines the final price of the product, the producer normally has the freedom to adjust production up or down. Take oil as an example. If the price of oil falls, the producer may offer less for sale, or even leave the market altogether if the price goes too low. If the price rises, the producer may offer more output for sale to take advantage of the better prices. Reading Check Synthesizing How might a producer of bicycles adjust supply when prices decrease? Change in Supply MAIN Idea Several factors can contribute to a change in supply. Economics & You Can you think of a time when you wanted to buy something, but the product was sold out everywhere? Read on to learn about factors that can affect supply. Sometimes something happens to cause a change in supply, a situation where suppliers offer different amounts of products for sale at all possible prices in the market. This is not the same as the change in quantity supplied illustrated in Figure 5.1, because now we are looking at situations where the quantity changes even though the price remains the same. For example, the supply schedule in Figure 5.3 shows that producers are now willing to offer more CDs for sale at every price than before
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. Where 6 units were offered at a price of $15, now there are 13. Where 11 were offered at a price of $25, 18 are now offered, and so on. Figure 5.3 A Change in Supply A S UPPLY S CHEDULE B C HANGE IN S UPPLY Price $30 25 20 15 10 5 S 13 11 9 6 3 0 S1 20 18 16 13 9 3 e c i r P $30 25 20 15 10 5 0 Decrease in supply b a S a’ S1 b’ Increase in supply 3 6 11 9 Quantity 13 16 18 20 A change in supply means that suppliers will supply different quantities of a product at the same price. When we plot the numbers from the supply schedule, we get two separate supply curves. An increase in supply appears as a shift of the supply curve to the right. A decrease in supply appears as a shift of the supply curve to the left. Economic Analysis How do change in supply and change in quantity supplied differ? Technology In this Ford manufacturing plant, robots assemble the body of a new Fusion sedan. What effect does the introduction of new technology have on the supply curve? When both old and new quantities supplied are plotted in the form of a graph, it appears as if the supply curve has shifted to the right, showing an increase in supply. For a decrease in supply to occur, less would be offered for sale at all possible prices, and the supply curve would shift to the left. Changes in supply, whether increases or decreases, can occur for several reasons. As you read, keep in mind that all but the last reason—a change in the number of sellers—affects both the individual and the market supply curves. Cost of Resources A change in the cost of productive inputs such as land, labor, and capital can cause a change in supply. Supply might increase because of a decrease in the cost of inputs such as labor or packaging. If the price of the inputs drops, producers are willing to produce more of a product, thereby shifting the supply curve to the right. An increase in the cost of inputs has the opposite effect. If labor or other costs rise, producers would not be willing to produce as many units. Instead, they would offer fewer products for sale, and the supply curve would shift to the left. Productivity Productivity goes up whenever more output is produced using the same amount of imput. When management trains or motivates its workers, productivity usually goes up. Productivity
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should also go up if workers decide to work harder or more efficiently. In each case, more output is produced at every price, which shifts the supply curve to the right. On the other hand, if workers are unmotivated, untrained, or unhappy, then productivity could decrease. The supply curve then shifts to the left because fewer goods are produced at every possible price. Technology New technology tends to shift the supply curve to the right. The introduction of a new machine or a new chemical or industrial process can affect supply by lowering the cost of production or by increasing productivity. For example, improvements in the fuel efficiency of jet aircraft engines have lowered the cost of providing passenger air service. When production costs go down, the producer is usually able to produce more goods and services at all possible prices in the market. Oliver Berg/dpa/Corbis CHAPTER 5 Supply 121 Subsidies Some subsidies pay for farmers not to farm some land to avoid overproduction. Why does the federal government pay such subsidies? subsidy government payment to encourage or protect a certain economic activity New technologies do not always work as expected, of course. Equipment can break down, or the technology—or even replacement parts—might be difficult to obtain. This would shift the supply curve to the left. These examples are exceptions, however. New technologies are usually expected to be beneficial, or producers would not be interested in them. Taxes and Subsidies Firms view taxes as a cost of production, just as they do raw materials and labor. If a company pays taxes on inventory or pays fees for a license to produce, the cost of production goes up. This causes the supply curve to shift to the left. However, if taxes go down, then production costs go down as well. When this happens, supply normally increases and the supply curve shifts to the right. Technology and Supply New technology can affect supply. But did you realize that supply can also affect technology? When supplies are low and prices are high, companies have an incentive to use technology to develop substitute products they can sell for less. If the price of oil gets too high, for example, there is more of an incentive to develop new technologies for solar, geothermal, or wind power. 122 UNIT 2 Microeconomics: Prices and Markets LUCKY COW © 2003 Mark Pett. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. A subsidy is a government payment to an individual, business, or other group to encourage or protect a certain type of economic
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activity. Subsidies lower the cost of production, encouraging current producers to remain in the market and new producers to enter. When subsidies are repealed, costs go up, producers leave the market, and the supply curve shifts to the left. Historically, many farmers in the milk, cotton, corn, wheat, and soybean industries received subsidies to support their income. Some farmers would have quit farming without these subsidies. Instead, the subsidies kept them in business and even attracted additional farmers into the industry—thereby shifting the market supply curve to the right. Expectations Expectations about the future price of a product can also affect supply. If producers think the price of their product will go up, they may make plans now to produce more later on. When the new production is ready, the market supply curve will increase, or shift to the right. On the other hand, producers may expect lower future prices. In this case, they may try to produce something else or even stop producing altogether—causing the supply curve to shift to the left. Expectations can also affect the price a firm plans to pay for some of the inputs used in production, so expectations can affect a business in a number of different ways. This is often compounded by events in the news, so expectations tend to change relatively frequently. Government Regulations When the government establishes new regulations, the cost of production can change, causing a change in supply. For example, when the government requires new auto safety features such as air bags or emission controls, cars cost more to produce. Producers adjust to the higher production costs by producing fewer cars at every possible price. In general, increased—or tighter— government regulations restrict supply, causing the supply curve to shift to the left. Relaxed government regulations allow producers to lower the cost of production, which results in a shift of the supply curve to the right. Number of Sellers All of the factors we have discussed so far can cause a change in an individual firm’s supply curve and, consequently, the market supply curve. It follows, therefore, that a change in the number of suppliers can cause the market supply curve to shift to the right or left. As more firms enter an industry, the supply curve shifts to the right because more products are offered for sale at the same prices as before. In other words, the larger the number of suppliers, the greater the market supply. However, if some suppliers leave the market, fewer products are offered for sale at all possible prices. This causes supply to decrease, shifting the curve
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to the left. In the real world, sellers are entering and leaving individual markets all the time. You see this in your own neighborhood when one store closes and another opens in its place. Spencer Grant/PhotoEdit Personal Finance Handbook See pages R20–R23 for more information on getting a job. Changes in technology can also impact the number of sellers. For example, recently the Internet has attracted a large number of new businesses, as almost anyone with some Internet experience and a few thousand dollars can open an online store. Because of the ease of entry into these new markets, selling a product is no longer just for the big firms. Reading Check Explaining Why do factors that cause a change in individual supply also affect the market demand curve? CAREERS Retail Salesperson The Work * Demonstrate products and interest customers in merchandise in an efficient and courteous manner * Stock shelves, take inventory, prepare displays * Record sales transactions and possibly arrange for product’s safe delivery Qualifications * Ability to tactfully interact with customers and work under pressure * Knowledge of products and the ability to communicate this knowledge to the customer * Strong business math skills for calculating prices and taxes * No formal education required, although opportunities for advancement may depend on a college degree Earnings * Median hourly earnings (including commissions): $8.98 Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 5 Supply 123 Figure 5.4 Elasticity of Supply The elasticity of supply is a measure of how quantity supplied responds to a price change. If the change in quantity supplied is more than proportional to the price change, supply is elastic; if it is less than proportional, it is inelastic; and if it is proportional, it is unit elastic. Economic Analysis Which factors determine whether a firm’s supply curve is elastic or inelastic? A C e c i r P $2 1 0 S 1 2 4 3 Quantity 5 6 7 e c i r P $2 1 0 S 1 2 4 3 Quantity 5 6 7 B S 1 2 4 3 Quantity 5 6 7 D D E Type of elasticity Change in quantity supplied due to a change in price Elastic More than proportional Unit elastic Proportional Inelastic Less than proportional e c i r P $2 1 0 supply elasticity a measure of how the quantity supplied responds to a change in price Elasticity of Supply MAIN Idea The response to a change in price varies for different products. Economics & You You learned earlier that demand can be elastic, in
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elastic, or unit elastic. Read on to learn about the elasticity of supply. Just as demand has elasticity, supply also has elasticity. Supply elasticity is a measure of the way in which the quantity supplied responds to a change in price. If an increase in price leads to a proportionally larger increase in output, supply is elastic. If an increase in price causes a proportionally smaller change in output, supply is inelastic. If an increase in price causes a proportional change in output, supply is unit elastic. As you might imagine, there is very little difference between supply and demand elasticities. If quantities of a product are being purchased, the concept is demand elasticity. If quantities of a product are being brought to market for sale, the concept is supply elasticity. In both cases, elasticity is simply a measure of the way quantity adjusts to a change in price. Three Elasticities Figure 5.4 illustrates three examples of supply elasticity. The supply curve in Panel A is elastic because the change in price causes a proportionally larger change in quantity supplied. Doubling the price from $1 to $2 causes the quantity brought to market to triple from two to six units. 124 UNIT 2 Microeconomics: Prices and Markets Panel B shows an inelastic supply curve. In this case, a change in price causes a proportionally smaller change in quantity supplied. When the price doubles from $1 to $2, the quantity brought to market goes up only 50 percent, or from two units to three units. Panel C shows a unit elastic supply curve. Here a change in price causes a proportional change in the quantity supplied. As the price doubles from $1 to $2, the quantity brought to market also doubles. Determinants of Supply Elasticity The elasticity of a producer’s supply curve depends on the nature of its production. If a firm can adjust to new prices quickly, then supply is likely to be elastic. If the nature of production is such that adjustments take longer, then supply is likely to be inelastic. The supply curve for nuclear power, for example, is likely to be inelastic in the short run. No matter what price is being offered, electric utilities will find it difficult to increase output because of the huge amount of capital and technology needed—not to mention the issue of extensive government regulation—before nuclear production can be increased. However, the supply curve is likely to be elastic for many toys, candy, and other products that can be
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made quickly without huge amounts of capital and skilled labor. If consumers are willing to pay twice the price for any of these products, most producers will be able to gear up quickly to significantly increase production. Unlike demand elasticity, the number of substitutes has no bearing on supply elasticity. In addition, neither the ability to delay the purchase nor the portion of income consumed are important. Instead, only production considerations determine supply elasticity. If a firm can react quickly to a changing price, then supply is likely to be elastic. If the firm takes longer to react to a change in prices, then supply is likely to be inelastic. Reading Check Comparing How are the elasticities of supply and demand similar? How do they differ? SECTION 1 Review Vocabulary 1. Explain the significance of supply, Law of Supply, 3. Explaining What is the difference between a change in supply and a change in quantity supplied? supply schedule, supply curve, market supply curve, quantity supplied, change in quantity supplied, change in supply, subsidy, and supply elasticity. Main Ideas 2. Determining Cause and Effect Use a graphic organizer like the one below to explain how a change in the price of an item affects the quantity supplied. Original quantity supplied Price increase Price decrease Quantity supplied Quantity supplied 4. Describing How does the quantity supplied change when the price doubles for a unit elastic product? Critical Thinking 5. The BIG Idea Explain why the supply curve slopes upward. 6. Analyzing Visuals Look at Figure 5.4 on page 124. How do the supply curves in the three panels differ? How does that difference reflect the types of elasticity? 7. Comparing and Contrasting Explain how supply is different from demand. Applying Economics 8. Elasticity of Supply If you were a producer, what might prevent you from increasing the quantity supplied in response to an increase in price? Explain. CHAPTER 5 Supply 125 CASE STUDY “Green” Suppliers From Black Gold to Golden Corn? As the world supply of oil is spread among developing nations and becomes increasingly expensive, Americans are looking for alternative fuels. One option is ethanol, a renewable energy source made from corn and other plants. Ethanol suppliers and automakers are touting E85—a mixture of 15 percent gasoline and 85 percent ethanol—as a cleaner, domestic substitute for America’s gas tanks. Aventine and VeraSun Aventine Renewable Energy, Inc., is just one ethanol supplier that is banking on the potential of plants. So far it�
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�s paying off. Aventine reported net income of $32 million on revenues of $935 million in 2005. That is an increase of 10 percent from 2004. Another ethanol supplier, VeraSun Energy Corp., has teamed up with General Motors and Ford to make E85 more available. Revenues for VeraSun look promising—from $194 million in 2004 to $111 million in just the first quarter of 2006. U.S. F UEL E THANOL P RODUC TION 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 1980 1985 1990 1995 Year 2000 2005 2010 Sources: U.S. Energy Information; Renewable Fuels Association U.S. E THANOL R EFINERIES Refineries in production Refineries under construction Source: Renewable Fuels Association Drawbacks vs. Benefits Ethanol does have some drawbacks. Only about 600 of the 180,000 U.S. service stations supply it. You also have to fill up more often, because ethanol contains less energy than gasoline. In addition, you have to drive a flexible-fuel vehicle (FFV) to use it. On the upside, ethanol yields about 26 percent more energy than it takes to produce it. Such a high yield is possible because sunlight is “free” and farming techniques have become highly efficient. As for the labor force, the ethanol industry supported the creation of more than 153,000 U.S. jobs in 2005. Perhaps the greatest benefit of increased ethanol supply will be reducing U.S. dependence on foreign oil. Analyzing the Impact 1. Comparing and Contrasting What are the advantages and disadvantages of E85? 2. Drawing Conclusions What is the relationship between the increased cost of oil and the supply of ethanol? 126 UNIT 2 Microeconomics: Prices and Markets SECTION 2 The Theory of Production GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn how a change in the variable input called “labor” results in changes in output. Content Vocabulary • production function • marginal product (p. 128) • short run (p. 128) • long run (p. 129) • total product (p. 129) (p. 129) • stages of production (p. 129) • diminishing returns (p. 130) • hypothetical (p. 128) • contributes (p. 130) Reading Strategy Listing As you read about production, complete a graphic organizer
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similar to the one below by listing what occurs during the three stages of production. Stage I Stage II Stage III —TIME COMPANIES IN THE NEWS The Hole in the Pipeline On December 5 [2005], known as Blank Monday in the surfing world, the $4.5 billion industry’s core snapped like a board caught in the Banzai Pipeline. Reason? The closure of Gordon (Grubby) Clark’s four-decade virtual monopoly on polyurethane blanks, the raw material for most surfboards. (Shapers then customize them for surfers.) Clark’s company produced 80% of blanks worldwide, and his sudden exit left surfers treading water as board prices doubled and deliveries were cut off. One man’s wipeout, though, could be another’s dream wave. Harold Walker and Gary Linden have quadrupled Walker Foam’s staff and are scouting for a new factory, hoping to produce 800 blanks a day by July, up from 125 now. ■ Changes in manufacturing, such as the fourfold increase in staff described in the news story above, happen all the time in any type of business. In fact, if you have ever worked in the fast food industry, you already know that the number of workers is the easiest factor of production for a business to change. How many times, for example, have you or one of your friends been called in when the business got busy, or were sent home when sales slowed down? Because it is so easy for firms to change the number of workers it employs whenever demand changes, labor is often thought of as being the variable factor of production. Darryl Bush/San Francisco Chronicle/Corbis CHAPTER 5 Supply 127 production function a graph showing how a change in the amount of a single variable input changes total output short run production period so short that only the variable inputs (usually labor) can be changed The Production Function MAIN Idea The production function shows how output changes when a variable input such as labor changes. Economics & You You have learned that changes in demand or supply can be illustrated with graphs. Read on to learn how changes in input are illustrated. Production can be illustrated with a production function—a figure that shows how total output changes when the amount of a single variable input (usually labor) changes while all other inputs are held constant. The production function can be illustrated with a schedule, such as the one in Panel A of Figure 5.5, or with a graph like the one in
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Panel B. Both panels list hypothetical output as the number of workers changes from zero to 12. According to the numbers in Panel A, if no workers are used, there is no output. If the number of workers goes up by one, output rises to 7. Add another worker and total output rises to 20. We can use this information to construct the production function that appears as the graph in Panel B, where the number of variable inputs is shown on the horizontal axis, and total production on the vertical axis. The Production Period When economists analyze production, they focus on the short run, a period so brief that only the amount of the variable input can be changed. The production function in Figure 5.5 reflects the short run because only the total number of workers changes. No changes occur in the amount of machinery, technology or land used. Thus, any change in output must be caused by a change in the number of workers. Figure 5.5 Short-Run Production See StudentWorks™ Plus or glencoe.com. A T HE P RODUCTION S CHEDULE Regions of production Marginal product* Total product Number of workers 10 11 12 0 7 20 38 62 90 110 129 138 144 148 145 135 0 7 13 18 24 28 20 19 9 6 4 –3 –10 Stage I Stage II Stage III * All figures in terms of output per day B T HE P RODUCTION F UNCTION 160 140 120 100 80 60 40 20 0 Stage I Stage II Stage III 1 2 3 4 5 6 7 8 9 10 11 12 13 Variable input: number of workers Short-run production can be shown both as a schedule and as a graph. In Stage I, total output increases rapidly with each worker added. In Stage II, output still increases, but at a decreasing rate. In Stage III output decreases. Economic Analysis How does marginal product help identify the stages of production? Other changes take place in the long run, a period long enough for the firm to adjust the quantities of all productive resources, including capital. For example, a firm that reduces its labor force today may also have to close down some factories later on. These are long-run changes because the amount of capital used for production changes. Total Product The second column in Figure 5.5 shows total product, or the total output produced by the firm. As you read down the column, you will see that zero units of total output are produced with zero workers, seven are produced with one worker, and so on. Again, this is a short
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-run relationship, because the figure assumes that only the amount of labor varies while the amount of other resources used remains unchanged. Now that we have total product, we can easily see how we get our next measure. Marginal Product The measure of output shown in the third column in Figure 5.5 is an important concept in economics. The measure is marginal product, the extra output or change in total product caused by adding one more unit of variable input. As we see in the figure, the marginal product, or extra output, of the first worker is 7. Likewise, the marginal product of the second worker is 13. If you look down the column, you will see that the marginal product for every worker is different, with some even being negative. Finally, note that the sum of the marginal products is equal to the total product. For example, the marginal products of the first and second workers is 7 plus 13, or 20—the same as the total product for two workers. Likewise, the sum of the marginal products of the first three workers is 7 plus 13 plus 18, or 38—the total output for three workers. Reading Check Analyzing Why does the produc- tion function represent short-run production? Tim Boyle/Getty Images Short Run When companies want to make quick changes in output, they usually change the number of workers. Why is a change in the number of workers considered a short-run change? long run production period long enough to change the amounts of all inputs total product total output or production by a firm marginal product extra output due to the addition of one more unit of input stages of production phases of production that consist of increasing, decreasing, and negative marginal returns Stages of Production MAIN Idea The stages of production help companies determine the most profitable number of workers to hire. Economics & You If you were a business owner, how would you decide on the number of workers you would hire? Read on to find out how the production function could help you. In the short run, every firm faces the question of how many workers to hire. To answer this question, let us take another look at Figure 5.5, which shows three distinct stages of production: increasing returns, diminishing returns, and negative returns. Stage I—Increasing Marginal Returns Stage I of the production function is the phase in which the marginal product of each additional worker increases. This happens because as more workers are added, they can cooperate with each other to make better use of their equipment. CHAPTER 5 Supply 129 diminishing returns stage where output
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increases at a decreasing rate as more units of variable input are added As we see in Figure 5.5, the first worker produces 7 units of output. The second is even more productive, with a marginal product of 13 units, bringing total production to 20. As long as each new worker contributes more to total output than the worker before, total output rises at an increasing rate. According to the figure, the first five workers are in Stage I. When it comes to hiring workers, companies do not knowingly produce in Stage I. When a firm learns that each new worker increases output more than the last, it tries to hire yet another worker. Soon, the firm finds itself in the next stage of production. Stage II—Decreasing Marginal Returns In Stage II, the total production keeps growing, but it does so by smaller and smaller amounts. Each additional worker, then, is making a diminishing, but still positive, contribution to total output. Stage II illustrates the principle of decreasing or diminishing returns—the stage where output increases at a diminishing rate as more variable inputs are added. In Figure 5.5, Stage II begins when the sixth worker is hired, because the 20- unit marginal product of that worker is less than the 28- unit marginal product of the fifth worker. The stage ends when the tenth worker is added, because marginal products are no longer positive after that point. Stage III—Negative Marginal Returns If the firm hires too many workers, they will get in each other’s way, causing output to fall. Stage III, then, is where the marginal products of additional workers are negative. For example, the eleventh worker has a marginal product of minus three, and the twelfth’s is minus 10, causing output to fall. Because most companies would not hire workers if this would cause total production to decrease, the number of workers a firm hires can only be found in Stage II. As we will see in the next section, the exact number of workers to be hired also depends on the revenue from the sale of the output. For now, however, we can say that the firm in Figure 5.5 will hire from 6 to 10 workers. Reading Check Interpreting What is unique about the third stage of production? SECTION 2 Review Vocabulary 1. Explain the significance of production function, short run, long run, total product, marginal product, stages of production, and diminishing returns. Main Ideas 2. Describing How does the length of the production period affect the output of a firm?
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3. Explaining Use a graphic organizer like the one below to explain how marginal product changes in each of the three stages of production. Critical Thinking 4. The BIG Idea Explain how a change in inputs affects production. 5. Analyzing Visuals Look at Figure 5.5 on page 128. Explain what happens to marginal product when production moves from Stage II to Stage III. 6. Sequencing Information You need to hire workers for a project and add one worker at a time to measure the added contribution of each worker. At what point will you stop hiring workers? Relate this process to the three stages of the production function. Stage of production Marginal product Applying Economics I II III 7. Diminishing Returns Provide an example of a time when you entered a period of diminishing returns or even negative returns. Explain why this might have occurred. 130 UNIT 2 Microeconomics: Prices and Markets ENTREPRENEUR Profiles in Economics Kenneth I. Chenault (1952– ) • first African American to be CEO of a top-100 company • responsible for continuing American Express’s 155-year- old tradition of “reinvention” during global change Stepping Stones Kenneth Chenault did not start his career in business. Instead, he earned an undergraduate degree in history and a law degree at Harvard. He had keen instincts for business, however, and worked for a management consulting firm before joining American Express in 1981. At first, Chenault was responsible for strategic planning. His intelligence and hard work moved him up the corporate ranks. Each promotion brought him new challenges and opportunities. Tools of Success In 2001 Chenault became chairman and CEO of American Express. When the terrorist attacks of 9/11 brought a downturn for the company, Chenault acted fast to adjust to market conditions. He changed the focus of American Express from telephone and mail to the Internet. He also cut the workforce by 15 percent. “We had to focus on the moderate and long-term,” he explained. “In volatile times, leaders are more closely scrutinized. If you cannot step up in times of crisis, you will lose credibility.” Returning to Basics Four years later, Chenault decided to refocus on “plastic.” American Express sold off its many financial planning services and regrouped around its core business—credit cards, corporate travel cards, and “reloadable” traveler’s checks. In addition, a 2004 Supreme Court decision on an antitrust suit ended Visa
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’s and Mastercard’s control over U.S. bank cards—a $2.1 trillion business. This opened the door for U.S. banks to issue American Express cards. Examining the Profile 1. Summarizing How did Chenault’s decisions improve American Express? 2. Evaluating Do you agree with Chenault’s claim that being adaptable to change is the most important strategy for a successful business? Amilcar/Liaison/Getty Images As chairman and CEO of American Express, Kenneth Chenault believes the key to success in the global economy is adaptability. “It’s not the strongest or the most intelligent who survive, but those most adaptive to change.” CHAPTER 5 Supply 131 SECTION 3 Cost, Revenue, and Profit Maximization GUIDE TO READING Section Preview In this section, you will learn how businesses analyze their costs and revenues, which helps them maximize their profits. Content Vocabulary • fixed costs (p. 133) • overhead (p. 133) • variable costs (p. 133) • total cost (p. 134) • marginal cost (p. 134) • e-commerce (p. 135) • break-even point (p. 135) • total revenue (p. 136) • marginal revenue (p. 136) • marginal analysis (p. 137) • profit-maximizing quantity of output (p. 137) Academic Vocabulary • conducted (p. 135) • generates (p. 136) Reading Strategy Explaining As you read the section, complete a graphic organizer similar to the one below by explaining how total revenue differs from marginal revenue. Then provide an example of each. Total revenue is: Marginal revenue is: Example: Example: —BusinessWeek COMPANIES IN THE NEWS FedEx Saves the Day As soon as Motion Computing Inc. in Austin, Texas, receives an order for one of its $2,200 tablet PCs, workers at a supplier’s factory in Kunshan, China, begin assembling the product. When they’ve finished, they individually box each order and hand them to a driver from FedEx Corp., who trucks it 50 miles to Shanghai, where it’s loaded on a jet bound for Anchorage before a series of flights and truck rides finally puts the product into the customer’s hands. Elapsed time: as little as five days. Motion’s inventory costs? Nada. Zip. Zilch.
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“We have no inventory tied up in the process anywhere,” marvels Scott Eckert, Motion’s chief executive. “Frankly, our business is enabled by FedEx.” There are thousands of other Motion Computings that, without FedEx, would be crippled by warehouse and inventory costs. ■ The news story above features a problem that all businesses, nonprofit organizations, and even individuals face—that of having to deal with the costs of running an organization. Scott Eckert could have decided to build a warehouse to store an inventory of tablet PCs waiting for future orders. Instead, he builds the tablet PCs one order at a time and uses a shipping company to deliver orders immediately. Anyone who is in charge of a business or a nonprofit organization spends a lot of time with costs. The task may be to identify the costs, and at other times it may be to reduce them. Our first task here, however, is to classify the costs. 132 UNIT 2 Microeconomics: Prices and Markets ©2006 FedEx fixed costs costs that remain the same regardless of level of production or services offered overhead broad category of fixed costs that includes rent, taxes, and executive salaries variable costs production costs that change when production levels change Measures of Cost MAIN Idea Businesses analyze fixed, variable, total, and marginal costs to make production decisions. Economics & You Are you involved in student government? Organizing events can often cost more than you might have originally thought. Read on to find out about the costs that organizations face. Because businesses want to produce efficiently, they must keep an eye on their costs. For purposes of analysis, they use several measures of cost. Fixed Costs The first measure is fixed costs—the costs that an organization incurs even if there is little or no activity. When it comes to this measure of costs, it makes no difference whether the business produces nothing, very little, or a large amount. Total fixed costs, sometimes called overhead, remain the same. Fixed costs include salaries paid to executives, interest charges on bonds, rent payments on leased properties, and state and local property taxes. Fixed costs also include depreciation—the gradual wear and tear on capital goods through use over time. A machine, for example, will not last forever, because its parts will wear out slowly and eventually break. Variable Costs Other costs are variable costs, or costs that change when the business’s rate of operation or output changes. While fixed costs are generally associated with machines and other capital goods, variable costs are usually associated with labor
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and raw materials. For example, wage-earning workers may be laid off or work overtime as output changes. Other examples of variable costs include electric power to run machines and freight charges to ship the final product. For most businesses, the largest variable cost is labor. If a business wants to hire one worker to produce seven units of output per day, and if the worker costs $90 per day, the total variable cost is $90. If the business wants to hire a second worker to produce additional units of output, then its total variable costs are $180, and so on. Costs Businesses need to consider both fixed costs, such as rent and taxes, and variable costs, such as labor. Why can electricity be considered a variable cost Figure 5.6 Production, Costs, and Revenues When we add the costs and revenues to the production schedule, we can find the firm’s profits. Note that fixed costs don’t change. Marginal cost and marginal revenue are used to determine the level of productivity with the maximum level of profits. Economic Analysis How do total costs differ from marginal costs? P RODUCTION S CHEDULE C OSTS R EVENUES P ROFIT Regions of production Number of workers Total product Marginal product 10 11 12 0 7 20 38 62 90 110 129 138 144 148 145 135 0 7 13 18 24 28 20 19 9 6 4 –3 –10 Stage I Stage II Stage III Total fixed cost $50 50 50 50 50 50 50 50 50 50 50 50 50 Total variable cost Total cost Marginal cost Total revenue Marginal revenue $0 90 180 270 360 450 540 630 720 810 900 990 $50 140 230 320 410 500 590 680 770 860 950 1,040 1,080 1,130 -- $12.86 6.92 5.00 3.75 3.21 4.50 4.74 10.00 15.00 22.50 -- -- $0 105 300 570 930 1,350 1,650 1,935 2,070 2,160 2,220 2,175 2,025 -- $15 15 15 15 15 15 15 15 15 15 15 15 Total profit –$50 –35 70 250 520 850 1,060 1,210 1,300 1,300 1,270 1,135 895 total cost the sum of fixed costs and variable costs marginal cost extra cost of producing one additional unit of production Total Cost Figure 5.6 shows the total cost of production, which is the sum of
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the fixed and variable costs. Total cost takes into account all of the costs a business faces in the course of its operations. If the business decides to use six workers costing $90 each to produce 110 units of total output, then its total cost will be $590—the sum of $50 in fixed costs plus $540 of variable costs. Skills Handbook Marginal Cost See page R51 to learn about Using Tables and Charts. The most useful measure of cost is marginal cost—the extra cost incurred when producing one more unit of output. 134 UNIT 2 Microeconomics: Prices and Markets In fact, marginal cost is more useful than total cost because it shows the change in total variable costs when output increases. Figure 5.6 shows that the addition of the first worker increases total product by seven units. Because total variable costs increased by $90, each additional unit of output has a marginal cost of $12.86, or $90 divided by seven. If a second worker is added, 13 more units of output will be produced for an additional cost of $90. This means that the extra, or marginal, cost of producing each new unit of output is $90 divided by 13, or $6.92. Reading Check Analyzing If a firm’s total output increases, will the fixed costs increase? Explain. Applying Cost Principles MAIN Idea Fixed and variable costs affect the way a business operates. Economics & You Have you or anyone you know purchased something on the Internet? Read on to find out about the costs of doing business online. The types of cost a firm faces may affect the way it operates. That is why owners analyze the costs they incur when they run their business. Costs and Business Operation For reasons largely related to costs, many stores are flocking to the Internet, making it one of the fastest-growing areas of business today. Stores do this because the overhead, or the fixed costs of operation, on the Internet is so low. Another reason is that a firm does not need as much inventory. People engaged in e-commerce—an electronic business conducted over the Internet—do not need to spend a large sum of money to rent a building and stock it with inventory. Instead, for just a fraction of the cost of a typical store, the e-commerce business owner can purchase Web access along with an e-commerce software package that provides everything from Web catalog pages to ordering, billing, and accounting software. Then, the owner of the e-commerce business store inserts pictures and descriptions of the
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products for sale into the software and loads the program. When customers visit the “store” on the Web, they see a range of goods for sale. In some cases, the owner has the merchandise in stock; in other cases, the merchant simply forwards the orders to a distribution center that handles the shipping. Either Courtesy of Amazon.com Inc. or its affiliates. All rights reserved. way, the fixed costs of operation are significantly lower than they would be in a typical retail store. Break-Even Point Finally, when a business knows about its costs, it can find the level of production that generates just enough revenue to cover its total operating costs. This is called the break-even point. For example, in Figure 5.6, the break-even point is between 7 and 20 units of total product, so at least two workers would have to be hired to break even. However, the break-even point only tells the firm how much it has to produce to cover its costs. Most businesses want to do more—they want to maximize the amount of profits they can make, not just cover their costs. To do this, they will have to apply the principles of marginal analysis to their costs and revenues. Reading Check Contrasting What are the differences between an e-commerce store and a traditional business? e-commerce electronic business conducted over the Internet break-even point production level where total cost equals total revenue E-Commerce Companies such as Amazon.com have been able to offer a wide range of products while keeping their overhead low. What helps e-commerce firms to reduce cost? CHAPTER 5 Supply 135 &The Global Economy YOU It Is a Small World... After All If you can’t find a product at a local store, you can browse millions of Internet sources to find what you’re looking for. It’s a simple process that, like any other transaction, involves a buyer and a seller. The Internet serves as a neutral venue for buyers and sellers to come together. What makes this such a unique global process is the efficient shipping that allows you to receive your product in a matter of days from such faraway places as China, the United Kingdom, and Australia. Previously a luxury, shipping goods from country to country—and continent to continent—has expanded the global marketplace with overnight and express mail options. Companies such as DHL, FedEx, and UPS work around the clock—and around the world—delivering packages to businesses and consumers. FedEx, for example
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, operates 120 flights weekly to and from Asia, including 26 out of China alone. A IR & G ROUND S HIPPING M ARKET 50% 45 40 35 30 25 20 15 10 5 0 FedEx UPS DHL Other National International Source: Market Research Service Center total revenue total amount earned by a firm from the sale of its products marginal revenue extra revenue from the sale of one additional unit of output Marginal Analysis and Profit Maximization MAIN Idea Businesses compare marginal revenue with marginal cost to find the level of production that maximizes profits. Economics & You You just learned about the importance of costs to a business. Read on to learn how businesses use this information to maximize their profits. Businesses use two key measures of revenue to find the amount of output that will produce the greatest profits. The first is total revenue, and the second is marginal revenue. The marginal revenue is compared to marginal cost to find the optimal level of production. Total Revenue The total revenue is all the revenue that a business receives. In the case of the firm shown in Figure 5.6 on page 134, total revenue is equal to the number of units sold multi plied by the average price per unit. So, if seven units are sold at $15 each, the total revenue is $105. If 10 workers are hired and their 148 units of total output sell for $15 each, then total revenue is $2,220. The calculation is the same for any level of output in the table. Marginal Revenue The more important measure of revenue is marginal revenue, the extra revenue a business receives from the production and sale of one additional unit of output. You can find the marginal revenue in Figure 5.6 by dividing the change in total revenue by the marginal product. For example, when the business employs five workers, it produces 90 units of output and generates $1,350 of total revenue. If a sixth worker is added, output increases by 20 units and total revenues increase to $1,650. If we divide the change in total revenue ($300) by the marginal product (20), we have marginal revenue of $15. 136 UNIT 2 Microeconomics: Prices and Markets As long as every unit of output sells for $15, the marginal revenue earned by the sale of one more unit will always be $15. For this reason, the marginal revenue appears to be constant at $15 for every level of output in Figure 5.6. In reality, this may not always be the case, as businesses often find that marginal
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revenues vary. Marginal Analysis Most people, as well as most businesses, use marginal analysis, a type of decision making that compares the extra benefits of an action to the extra costs of taking the action. Marginal analysis is useful in a number of situations, from our own individual decision making to production decisions made by corporations. In the case of our own individual decision making, it is usually best for us to take small, incremental steps to determine if the additional benefits from each step are greater than the additional costs. A business does the same thing. It adds more variable inputs (workers) and then compares the extra benefit (marginal revenue) to the additional cost (marginal cost). If the extra benefit exceeds the extra cost, then the firm hires another worker. Profit Maximization We can now use marginal analysis to find the level of output that maximizes profits for the business represented in Figure 5.6. The business would hire the sixth worker, for example, because the extra output would cost only $4.50 to produce while generating $15 in new revenues. Having made a profit with the sixth worker, the business would hire the seventh and eighth workers for the same reason. While the addition of the ninth worker neither adds to nor takes away from total profits, the firm would have no incentive to hire the tenth worker. If it did, it would quickly discover that profits would go down, and it would go back to using nine workers. When marginal cost is less than marginal revenue, more variable inputs should be hired to expand output. Eventually, the profit-maximizing quantity of output is reached when marginal cost and marginal revenue are equal, as shown in the last column in Figure 5.6. Other levels of output may generate equal profits, but none will be more profitable. Reading Check Summarizing Why do people, especially business owners, use marginal analysis? Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 5— Student Web Activities for an activity on the operation of a company. marginal analysis decision making that compares the extra costs of doing something to the extra benefits gained profit maximizing quantity of output level of production where marginal cost is equal to marginal revenue SECTION 3 Review Vocabulary 1. Explain the significance of fixed costs, overhead, Critical Thinking 4. The BIG Idea Explain how businesses use marginal variable costs, total cost, marginal cost, e-commerce, break-even point, total revenue, marginal revenue, marginal analysis, and profit-maximizing quantity of output
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. Main Ideas 2. Identifying Use a graphic organizer like the one below to identify examples of both fixed and variable costs. Fixed Costs Variable Costs analysis to maximize profits. 5. Analyzing Visuals Look at Figure 5.6 on page 134. Using the numbers in the figure, write a paragraph to explain in your own words how many workers this company should hire and why it should make this decision. Provide specific examples based on the information in the table. 6. Inferring If the total output of a business increases, what will happen to fixed costs? To variable costs? Applying Economics 7. Total Cost Many plants use several shifts of workers in 3. Explaining What is the difference between break-even output and profit-maximizing quantity of output? order to operate 24 hours a day. How do a plant’s fixed and variable costs affect its decision to operate around the clock? CHAPTER 5 Supply 137 NEWSCLIP Profit maximization is the goal of all American businesses. Many increase profits by keeping costs as low as possible. One company has taken cost-cutting to new “lows”: Steve & Barry’s University Sportswear. Steve & Barry’s Rules the Mall Steven Shore and Barry Prevor love to fill a void — about 3.5 million square feet of it. That’s how much space Steve & Barry’s University Sportswear took in U.S. shopping centers last year, the most of any mall-based chain. The co-CEOs soaked up that space by opening 62 supermarket-sized stores, almost doubling their outlets in one year, to 134. The privately held chain, which lures shoppers with casual clothing priced at $7.98 or less—a 40% discount to prices at WalMart Stores Inc. and Target Corp.—plans to operate more than 200 stores by yearend.... How can Steve & Barry’s charge so little? One reason: the cut-rate deals it negotiates with landlords. Most of its stores are in middle-market malls, which have seen rising vacancies.... Low rents are hardly the only way the men keep costs low. While malls usually give new tenants allowances of $20 to $30 a square foot to build interiors, the popularity of Steve & Barry’s has allowed the chain to command [allowances] as high as $80, considerably more than actual costs.... Item Carpenter jeans Polo shirt Baseball cap Hood
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ed sweatshirt Store Wal-Mart Target S&B’s Wal-Mart Target S&B’s Wal-Mart Target S&B’s Wal-Mart Target S&B’s Price $14.88 16.99 7.98 9.83 11.99 7.98 7.00 11.89 7.98 12.77 12.99 7.98 Sources: www.walmart.com, www.target.com, www.steveandbarrys.com 138 UNIT 2 Microeconomics: Prices and Markets Ara Koopelian Steve & Barry’s also saves money in purchasing. It buys direct from overseas factories, like many others, but cuts costs by accepting longer lead times. It also saves by offering steady production throughout the year rather than seasonal rampups. The chain cuts expenses further by deft navigation of import quotas and duties.... That’s why it buys more from factories in Africa and less from China than many rivals—most African countries face neither U.S. quotas nor duties. Advertising isn’t an expense Steve & Barry’s wrestles with, either—it relies mostly on word of mouth. —Reprinted from BusinessWeek Examining the Newsclip 1. Summarizing How has Steve & Barry’s University Sportswear cut costs? 2. Making Connections How do the cost-cutting steps help Steve & Barry’s increase its profits? CHAPTER 5 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Law of Supply When the price of a product goes up, quantity supplied goes up. When the price goes down, quantity supplied goes down. When the When the price goes price goes up... up... quantity quantity supplied supplied goes up. goes up. When the When the price goes price goes down... down... quantity quantity supplied supplied goes goes down. down. Production Function The production function helps us find the optimal number of variable units (labor) to be used in production. As workers are added in Stage I, production increases at an increasing rate. In Stage II, production increases at a decreasing rate because of diminishing returns. In Stage III, production decreases because more workers cannot make a positive contribution. T HE P RODUCTION F UNCTION 160 140 120 100 80 60 40 20 Stage I Stage II Stage III 3 4 11 2 Variable input: number of
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workers 10 9 6 5 8 7 12 13 Cost and Revenue While businesses have several types of costs, they can find the profitmaximizing quantity of output by comparing marginal cost to their marginal revenue. Cost Revenue Fixed cost: always the same and always has to be paid Variable cost: varies depending on level of production Marginal cost (MC) : extra cost per additional unit of output If MC = MR Profit- maximizing quantity of output Marginal revenue (MR): extra revenue from one additional unit of output Total revenue: revenue based on number of units multiplied by average price per unit CHAPTER 5 Supply 139 CHAPTER 5 Assessment & Activities Review Content Vocabulary Review Main Ideas On a separate sheet of paper, write the letter of the key term that best matches each definition below. a. change in quantity supplied b. diminishing returns c. fixed costs d. marginal analysis e. marginal product f. marginal revenue g. production function h. Law of Supply i. total cost j. change in supply k. overhead l. total product 1. a production cost that does not change as total business output changes 2. decision making that compares the additional costs with the additional benefits of an action 3. associated with Stage II of production 4. situation where the amount of products for sale changes while the price remains the same 5. a graphical representation of the theory of production 6. the additional output produced when one additional unit of input is added Section 1 (pages 117–125) 19. Describe what economists mean by supply. 20. Distinguish between the individual supply curve and the market supply curve. 21. Describe the factors that can cause a change in supply. 22. Identify the three types of elasticity, using a graphic organizer similar to the one below. Supply Elastic: Inelastic: Unit elastic: Section 2 (pages 127–130) 23. Explain the difference between total product and marginal product. 7. change in total revenue from the sale of one additional 24. Describe the three stages of production. unit of output 8. change in the amount of products for sale when the Section 3 (pages 132–137) price changes 25. Describe the relationship between marginal cost and 9. the sum of variable and fixed costs total cost. 10. principle that more will be offered for sale at high 26. Explain the difference between fixed and variable costs. prices than at lower prices 11. total output produced by a firm 12. total fixed costs 27. Discuss why businesses analyze their costs. 28. Explain how businesses determine their
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profit maximization output. Review Academic Vocabulary Critical Thinking On a separate sheet of paper, write a paragraph about “supply” that uses all of the following terms. 13. interaction 14. various 15. hypothetical 16. contributes 17. conducted 18. generates 29. The BIG Idea Imagine that gas prices have increased to $5.00 per gallon. What will happen to the supply of fuel-efficient cars in the short run and in the long run? Explain. 30. Determining Cause and Effect Explain why e-commerce reduces fixed costs. 140 UNIT 2 Microeconomics: Prices and Markets 31. Making Generalizations Why might production functions tend to differ from one firm to another? 32. Interpreting Return to the chapter opener activity on page 116. Now that you have learned about supply, review the questions you answered at the beginning of the chapter. How would you revise your earlier decisions on services and prices, and why? 33. Understanding Cause and Effect According to the Law of Supply, what will happen to the number of products a firm offers for sale when prices go down? What will happen if the cost of production increases while prices remain the same? 34. Drawing Conclusions Use a graphic organizer like the one below to illustrate what will happen to supply in each of the situations provided. Oranges Damaging frost Tractors Costs decrease Cars Federal taxes increase Applying Economic Concepts 35. Marginal Analysis Think about a recent decision you made in which you used the tools of marginal analysis. Describe in detail the problem, the individual steps you took to solve the problem, and the point at which you stopped taking further steps. Explain why you decided to make no further changes. 36. Overhead Overhead is a concern not just for businesses, but also for individuals. What overhead costs do you have to take into consideration if you want to own a car? Economics: Principles and Practices Web site at glencoe.com and click on Chapter 5—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Thinking Like an Economist 37. Label the following actions according to their placement in the stages of production: a. After many hours of studying, you are forgetting some of the material you learned earlier. b. You are studying for a test and learning rapidly. c. After a few hours, you are still learning but not as fast as before. Analyzing Visuals 38. Making Connections Look at Panel B in Figure 5.5 on page 128. Desc
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ribe the shape of the curve as it goes through the three different stages. How does the shape correspond to the total product and the marginal product listed in Panel A? Writing About Economics 39. Persuasive Writing Research the way government regulates a business or industry in your region. Write a short paper discussing how you think the regulation affects the supply curve of the product both for the firm and for the industry. Math Practice 40. Using the schedule below as a starting point, create a supply schedule and a supply curve that shows the following information: American automakers are willing to sell 200,000 cars per year when the price of a car is $20,000. They are willing to sell 400,000 when the price is $25,000 and 600,000 at a price of $30,000. Price $20,000 $25,000 Quantity supplied 200,000 CHAPTER 5 Supply 141 CHAPTER 6 Prices and Decision Making Why It Matters Have you ever wondered why famous athletes and entertainers make millions of dollars each year? Imagine that you are one of these athletes or entertainers and will be interviewed on a major television program. Knowing that the interviewer will ask you why you make so much money, prepare a list of 5 to 10 reasons that explain why you are worth your salary. Read Chapter 6 to learn about how economic systems allocate goods and services. The BIG Ideas 1. Markets exist when buyers and sellers interact, and market prices are set by the interaction of demand and supply. 2. Governments strive for a balance between the costs and benefits of their economic policies to promote economic stability and growth. Every day prices help buyers make decisions about the quantities of goods and services they buy. 142 UNIT 2 WireImageStock/Masterfile Economics: Principles and Practices Web site at glencoe.com and click on Chapter 6—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 Prices as Signals GUIDE TO READING Section Preview Reading Strategy In this section, you will learn that prices act as signals that help us allocate scarce resources. Explaining As you read the section, complete a graphic organizer similar to the one below by explaining the advantages of prices. Advantages of Prices —New Orleans Times-Picayune Content Vocabulary • price (p. 143) • rationing (p. 145) • ration coupon (p. 145) • rebate (p. 146) Academic Vocabulary • neutral (p. 144) • criteria (p. 145) PRODUCTS IN THE NEWS Katrina Fallout The local real
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estate market soared after Hurricane Katrina, with home prices recording double-digit increases and the number of sales remaining surprisingly strong.... During the final four months of 2005—the months after Katrina—the average sale price in the metropolitan area was $215,769, or 21 percent higher than the average price of all homes sold in 2004.... The strong real estate figures send the clearest signal yet that the New Orleans housing market is not dead. In fact, they might make the city more appealing than ever to national investors... looking to snatch up bargain properties they can sell down the road for a profit. ■ Life is full of signals that help us make decisions. For example, when we pull up to an intersection, we look to see if the traffic light is green, yellow, or red. We look at the other cars to see if any have their blinkers on, signaling their intentions to turn. While these are clear and obvious signals, there are other, more hidden ones. Pain, for example, signals you that something is wrong with your body. But have you ever thought about signals in economics? It turns out that something as simple as a price—the monetary value of a product as established by supply and demand—is a signal that helps us make economic decisions. Prices give information to buyers and sellers. High prices signal buyers to buy less and producers to produce more. Low prices signal buyers to buy more and producers to produce less. Even housing prices, as we read in the news story above, send signals. price monetary value of a product as established by supply and demand Peter Horree/Alamy Images CHAPTER 6 Prices and Decision Making 143 Advantages of Prices MAIN Idea Prices help the economy run smoothly by providing a good way to allocate resources. Economics & You Have you ever seen news reports about rising prices for building materials after a hurricane? Read on to learn how the price system helps us deal with natural disasters. Prices help producers and consumers decide the three basic questions of WHAT, HOW, and FOR WHOM to produce. Without prices, the economy would not run as smoothly, and allocation decisions would have to be made some other way. Prices perform this function well for several reasons. First, in a competitive market economy, prices are neutral because they favor neither the producer nor the consumer. Since prices are the result of competition between buyers and sellers, they represent compromises that both sides can live with. Second, prices in a market economy are flexible. Unforeseen events such as natural
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disasters and war affect the prices of many items. Buyers and sellers then react to the new level of prices and adjust their consumption and production accordingly. Before long, the system functions as smoothly again as it had before. The ability of the price system to absorb unexpected “shocks” is one of the strengths of a market economy. Third, most people have known about prices all their lives. As a result, prices are familiar and easy to understand. There is no ambiguity over a price—if something costs $1.99, then we know exactly what we have to pay for it. This allows people to make decisions quickly and efficiently, with a minimum of time and effort. Finally, prices have no cost of administration. Competitive markets tend to find their own prices without outside help or interference. No bureaucrats need to be hired, no committees formed, no laws passed, or other decisions made. Even when prices adjust from one level to another, the changes are usually so gradual that people hardly notice. Reading Check Summarizing In what way do prices perform the allocation function? &The Global Economy YOU Mobility on the Cheap Americans are constantly in motion. The popularity of cell phones and laptop computers illustrates this point. Luckily for on-the-go consumers, the prices of these mobile products are falling. The average cost of a laptop in 2000 was more than $2,000. Each year, the average price has dropped by several hundred dollars. Competition has played the biggest role in the downward spiral of profits for laptop makers. In 2006, the profit margin for most laptops was only $50. This meager profit means that manufacturers are aiming for high sales volume rather than high profit margins. They are also counting on consumers to spend more on expensive accessories, such as service plans, docking stations, and batteries. How does this competitive market impact you? Consumers can expect lower prices and a wider 144 UNIT 2 Microeconomics: Prices and Markets selection. In addition, the competition ensures innovation, as manufacturers search for the gadget or accessory that none of us can do without. A VERAGE L APTOP P RICES $2,000 e c i r P 1,500 1,000 500 2002 2000 Source: The Wall Street Journal. 2001 2004 2003 Year 2005 2006 Allocations Without Prices MAIN Idea Rationing has disadvantages that are not present in the price system. Economics & You How would you allocate goods like cars or food if there were no prices? Read on to learn about the problems associated with other systems. Prices help
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us make the everyday economic decisions that allocate scarce resources. But what would life be like without a price system? Would intelligence, good looks, or even political connections determine the allocations? These criteria may seem far-fetched, but this happens in countries with command economies. When the Baltimore Orioles played an exhibition baseball game in Cuba several years ago, there were not enough stadium seats for the local baseball fans who wanted to attend. Fidel Castro then solved the FOR WHOM questions by giving the seats to Communist Party members— whether or not they were baseball fans. Rationing Without prices, another system must be used to decide who gets what. One method is rationing—a system under which a government agency decides everyone’s “fair” share. Under such a system, people receive a ration coupon, a ticket or a receipt that entitles the holder to obtain a certain amount of a product. The coupon can be given to people outright, or the government can charge a modest fee that is less than the product’s market value. Rationing has been widely used during wartime, but it can lead to problems. Problems with Rationing The first problem with rationing is that almost everyone feels his or her share is too small. During the energy crisis of the early 1970s, the government made plans for, but never implemented, gasoline rationing. One problem was determining how to allocate Ed Quinn/Corbis Rationing This clerk in a grocery store in Cuba accepts ration coupons as payment for the products people are buying. How are ration coupons allocated? rationing system of allocating goods and services without prices ration coupon permit allowing holder to receive a given amount of a rationed product Skills Handbook See page R43 to learn about Comparing and Contrasting. the rationing coupons in a way that everyone would see as fair. A number of ways to allocate gas coupons were debated, but the issue of fairness was never resolved. A second problem is the administrative cost of rationing. Someone must pay the salaries and the printing and distribution costs of the coupons. In addition, no matter how much care is taken, some coupons will be stolen, sold, or counterfeited and used to get a product intended for someone else. A third problem is the negative impact on the incentive to produce. What if you were paid with ration coupons and you received the same number of coupons as your coworkers? Without the possibility of earning more coupons, you might lose some of your incentive to work. Reading Check Contrasting What are the differ-
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ences between the price system and rationing? CHAPTER 6 Prices and Decision Making 145 rebate partial refund of a product’s original price Prices as a System MAIN Idea Prices connect all markets in an economy. Economics & You Have you noticed ads for rebates on SUVs when gas prices soar? Read on to learn how these rebates are one way in which prices allocate resources between markets. Because of the difficulties with nonprice allocation systems, economists overwhelmingly favor the price system. In fact, prices do more than help individuals make decisions: they also serve as signals that help allocate resources between markets. Consider the way in which higher oil prices affected producer and consumer decisions when the price of oil went from under $35 to over $70 a barrel in 2005 and 2006. Because the demand for oil is basically inelastic, people spent a greater part of their income on energy. Higher energy costs left them with less to spend elsewhere. The SUV market was one of the first to feel the effects of high prices. Because most of these vehicles got poor gas mileage, people bought fewer SUVs, leaving dealerships with huge inventories. To move these inventories, some manufacturers offered consumers a rebate—a partial refund of the original price of the product. The rebate was the same as a temporary price reduction, because consumers were offered thousands of dollars back on each new car they bought. Other dealers offered zero-interest financing. Finally, automakers had to reduce their production of these vehicles. Ford Motor Company, for example, closed plants, laid off workers, and tried to sell more fuel-efficient cars. Many automobile workers who lost their jobs eventually found new ones in other industries. In the end, the result of higher international oil prices was to shift productive resources out of SUV production into other products. Although the adjustment process was painful for many in the industry, it was a natural and necessary shift of resources for a market economy. In the end, prices do more than convey information to buyers and sellers in a market: they also allocate resources between markets. This is why economists think of prices as a “system”—part of an informational network—that links all markets in the economy. Reading Check Identifying How do prices allocate resources between markets? SECTION 1 Review Vocabulary 1. Explain the significance of price, rationing, ration coupon, and rebate. Main Ideas 2. Describing What are the advantages of prices? 3. Identifying Use a graphic organizer like the one below to identify the problems associated with rationing. Problems
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of Rationing 4. Explaining Why are prices an efficient way to allocate goods and services? 146 UNIT 2 Microeconomics: Prices and Markets Critical Thinking 5. The BIG Idea Describe how prices help allocate scarce resources by answering the questions of WHAT, HOW, and FOR WHOM to produce. 6. Analyzing Visuals Look at the photograph on page 145. What effect does rationing seem to have on the number and variety of items in the store? 7. Understanding Cause and Effect Assume that there is a gasoline shortage and your state has imposed rationing. Write a paragraph about how this might affect you, your family, and your community. Applying Economics 8. Rationing List five items you would like to buy. How does the price of each item affect your decision to allocate scarce resources—your money and your time? CASE STUDY ‘I Bought It on eBay’ The World’s Online Marketplace Since its introduction in 1995, eBay has given rise to the phrase “I bought it on eBay.” Buyers and sellers flock to the online auction site to bid on and sell everything from snow and math tutoring to collectibles and used cars. The Perfect Price The site serves as an online forum where supply meets demand in a seamless process. Sellers enjoy the advantages of a huge customer base and little overhead. They also have the option to list a “reserve,” or minimum price. All of these features help maximize profits. Buyers appreciate the ability to browse millions of items, shop from home, and counter-offer with their own bid. Because eBay does not produce, sell, or distribute any of the products offered on its Web site, it makes money by charging a modest listing fee and commission for each item sold. In 2005 the number of registered eBay members topped 100 million, including potential buyers in more than 30 countries. EB AY R EVENUES’ 2001–2005 $ 2001 2002 2003 2004 2005 Year Source: moneycentral.msn.com E UROPEANS E ARNING AT L EAST 25% OF T HEIR I NCOME F ROM EB AY B USINESS Britain Germany France Italy Spain 0 10 20 50 40 30 Thousands 60 70 Source: eBay Inc. To some members, eBay is a great place to sell an item they no longer need or want, such as a baby stroller or CD. For others, eBay has turned from a hobby into a career. In 2005 more than 700,000 people in the United
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States earned full- or part-time income on eBay. Many sellers in Europe—especially Britain and Germany—also rely on eBay to make money. eBay Express In 2006 eBay faced serious competition from Google and Yahoo for a larger share of the e-commerce market. The company’s response was eBay Express, which allows shoppers to purchase products immediately without waiting a week for an auction to close. The hope is that a brand new audience will tap into the eBay experience. Analyzing the Impact 1. Summarizing How is price determined for an item on eBay? 2. Explaining What change did eBay make to attract more shoppers? CHAPTER 6 Prices and Decision Making 147 SECTION 2 The Price System at Work GUIDE TO READING Section Preview Reading Strategy In this section, you will learn how economic models help us understand prices in competitive markets. Content Vocabulary • economic model (p. 149) • surplus (p. 150) • equilibrium price (p. 149) • shortage (p. 151) Academic Vocabulary • voluntary (p. 149) • fluctuates (p. 153) Describing As you read the section, complete a graphic organizer similar to this by describing how a surplus and a shortage affect prices, demand, and supply. Surplus Shortage Effects Effects —adapted from The Miami Herald COMPANIES IN THE NEWS Want Prime Seats? Get Ready to Bid Bids on the best seats in the house for Madonna’s concert... could start at the face-value price of $350. Do I hear $450? Going once, going twice... Sold! To the person online. Tired of competition from scalpers, Ticketmaster and its clients are now auctioning “premium seats” to concerts, sports meets, and other events. The practice, dubbed “dynamic pricing,” allows customers to set their own prices. Competitors see it differently, saying the practice allows Ticketmaster to scalp its own tickets. (Scalping is a second-degree misdemeanor under Florida state law, punishable by up to 60 days in jail and a $500 fine.)... Dynamic pricing endorses a free market economic principle: namely, that the market determines the fair value of a ticket. ■ One of the most appealing features of a competitive market economy is that everyone who participates has a hand in determining prices. This is why economists consider prices to be neutral and impartial. The process of establishing a price, as you read in the news story above
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, can be complicated—or even contentious— because buyers and sellers have exactly the opposite hopes and desires. Buyers want to find good buys at low prices. Sellers hope for high prices and large profits. Neither can get exactly what they want, so some adjustment is necessary to reach a compromise. Will consumers pay too much for tickets? Most economists would argue that as long as the process is competitive and the transaction voluntary, then the price will be about right under a bidding system. 148 UNIT 2 Microeconomics: Prices and Markets Evan Agostini/Getty Images economic model a simplified version of a complex behavior expressed in the form of an equation, graph, or illustration (also see page 23) equilibrium price price where quantity supplied equals quantity demanded The Price Adjustment Process MAIN Idea In a market economy, prices seek their own equilibrium. Economics & You You learned earlier that the price system is flexible. Read on to find out how prices adjust to changes in the economy. Because transactions in a market economy are voluntary, the compromise that settles the differences between buyers and sellers must be to the benefit of both, or the compromise would not occur. A Market Model To show how the adjustment process works, we use the supply and demand illustration shown in Figure 6.1—one of the more popular “tools” used by economists. The figure illustrates how we can use an economic model to analyze behavior and predict outcomes. The data in the figure show the demand for and supply of CDs at various prices. You are already familiar with these numbers, because they are the same ones you saw when you learned about demand in Chapter 4 and supply in Chapter 5. Panel A combines information from the market demand schedule in Figure 4.2 on page 94 and the market supply schedule in Figure 5.2 on page 119. Panel B shows both the market demand curve and the market supply curve, again from those two earlier figures. Separately, each of these graphs represents the demand or supply side of the market. When the curves are combined, we have a complete model of the market, which will allow us to analyze how the interaction of buyers and sellers results in a price agreeable to all market participants. Note that the supply and demand curves intersect at a specific point. This point is called the equilibrium price, the price at which the number of units produced equals the number of units sold. It means that at this price there is neither a surplus nor a shortage of the product in the market. But how does the market reach this equilibrium price, and
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why does it settle at $15 rather Figure 6.1 Market Equilibrium A M ARKET D EMAND AND S UPPLY S CHEDULES Quantity demanded Quantity supplied Price $30 25 20 15 10 5 0 1 3 6 10 15 13 11 9 6 3 0 B M ARKET D EMAND AND S UPPLY C URVES Surplus/ shortage 13 10 6 0 –7 –15 e c i r P $30 25 20 15 10 5 0 S Equilibrium price 10 11 12 13 14 15 16 Quantity The schedules provide the quantities demanded and the quantities supplied at different prices. The last column lists the surpluses or shortages at each price. When the demand and supply at each price are plotted, they show that the curves intersect at a price of $15. This is the equilibrium price. Economic Analysis Why is the equilibrium price important? surplus situation where quantity supplied is greater than quantity demanded at a given price Skills Handbook See page R53 to learn about Comparing Data. than some other price? To answer these questions, we have to examine the reactions of buyers and sellers to different market prices. When we do this, we assume that neither the buyer nor the seller knows the final price, so we’ll have to find it using trial and error. Surplus We start on Day 1 with sellers thinking that the price will be $25. If you examine the supply schedule in Panel A of Figure 6.1, you see that suppliers will produce 11 units for sale at that price. However, the suppliers soon discover that buyers will purchase only one CD at a price of $25, leaving a surplus of 10. A surplus is a situation in which the quantity supplied is greater than the quantity demanded at a given price. The 10unit surplus at the end of Day 1 is shown in column four of Panel A in Figure 6.1 as the difference between the quantity supplied and the quantity demanded at the $25 price. It is also shown graphically in Panel A of Figure 6.2 as the horizontal distance between the supply and demand curves at a price of $25. This surplus shows up as unsold products on suppliers’ shelves, and it begins to take up space in their warehouses. Sellers now know that $25 is too high, and they know that they have to lower their price if they want to attract more buyers and dispose of the surplus. Therefore, the price tends to go down as a result of the surplus. The model cannot tell us how far the price
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will go down, but we can reasonably assume that the price will go down only a little if the surplus is small, and much more if the surplus is larger. Shortage Suppliers are more cautious on Day 2, so they anticipate a much lower price of $10. At that price, the quantity they are willing to supply changes to three CDs. However, as Panel B in Figure 6.2 shows, this price turns out to be too low. At a market price of $10, only three CDs are supplied and 10 are demanded—leaving a shortage of seven CDs. Figure 6.2 Surpluses and Shortages A S URPLUS B S HORTAGE e c i r P $30 25 20 15 10 5 0 Surplus = 10 10 Quantity 11 12 13 14 15 16 17 e c i r P $30 25 20 15 10 5 0 S Shortage = 10 Quantity 11 12 13 14 15 16 17 A surplus occurs when sellers produce more units than buyers will purchase at a given price. A shortage is the result of buyers wanting to purchase more units than sellers offer at a given price. Surpluses will cause prices to drop, and shortages will cause prices to rise until prices reach an equilibrium. Economic Analysis Why did the surplus shown in Panel A occur? See StudentWorks™ Plus or glencoe.com. Equilibrium Price Supply and demand determine the final price of a product. Why does the price differ for the CDs in the cartoon shortage is a situation in which the quantity demanded is greater than the quantity supplied at a given price. When a shortage happens, producers have no more CDs to sell, and they end the day wishing that they had charged a higher price for their products. As a result of the shortage, both the price and the quantity supplied will go up in the next trading period. While our model does not show exactly how much the price will go up, we can assume that the next price will be less than $25, which we already know is too high. Equilibrium Price If the new price is $20 on Day 3, the result will be a surplus of six CDs. This surplus will cause the price to drop again, but probably not below $10, which already proved to be too low. However, if the price drops to $15, the market will have found its equilibrium price. As you learned earlier, the equilibrium price is the price that “clears the market” by leaving neither a surplus nor a shortage at the end of the trading
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period. While our economic model of the market cannot show exactly how long it will take to reach equilibrium, the temporary Mike Baldwin/Cartoon Stock shortage situation where quantity supplied is less than quantity demanded at a given price e k M i surpluses and shortages will always be pushing the price in that direction. Whenever the price is too high, the surplus will tend to force it down. Whenever the price is too low, the shortage will tend to force it up. As a result, the market tends to seek its own equilibrium. When the equilibrium price of $15 is finally reached, it will tend to remain there because the quantity supplied is exactly equal to the quantity demanded. Something could come along to disturb the equilibrium, but then new shortages, new surpluses, or both would appear to push the price toward its new equilibrium level. Think of how much more difficult it would be to reach an equilibrium price if we did not have markets to help us with these decisions. You already learned that prices are neutral, flexible, understood by everybody, and free of administrative costs. It would be difficult to find another system that works equally well at setting the equilibrium price at exactly $15 and the equilibrium quantity at exactly six units. Also, when markets set prices, everybody has a hand in determining the outcome. Summarizing How do surpluses and shortages help establish the equilibrium price? CHAPTER 6 Prices and Decision Making 151 Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 6—Student Web Activities for an activity on prices. Explaining and Predicting Prices MAIN Idea Changes in supply and demand can result in changes in prices. Economics & You What happens to prices of concert tickets for bands that have become popular? Read on to find out how changes in demand affect prices. Economists use their market models to explain changes in prices. A change in price is normally caused by a change in supply, a change in demand, or changes in both. Elasticity is also important when predicting how prices are likely to change. Change in Supply Consider agriculture, which often experiences wide swings in prices from one year to the next. A farmer may keep up with all the latest developments and have the best advice experts can offer, but the farmer can never be sure what price to expect for the crop. For example, a soybean farmer may put in 500 acres of beans, hoping for a price of $9 a bushel. However, the farmer also knows that the actual price may
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end up being anywhere from $5 to $20. Weather is one of the main reasons for variations in agricultural prices. If it rains too much after planting, the seeds may rot or be washed away and the farmer must replant. If it rains too little, the seeds may not sprout. Even if the weather is perfect during the growing season, rain can still interfere with the harvest. The weather, then, often causes a change in supply. The result, shown in Panel A of Figure 6.3, is that the supply curve for agricultural products is likely to shift, causing the price to go up or down. At the beginning of the season, the farmer may expect supply to look like curve S. If a bumper, or record, crop is harvested, however, supply may look like S1. If severe weather strikes, supply may look like S2. In either case the price of soybeans is likely to change dramatically. Figure 6.3 Changes in Prices A F OOD P RICES 35 30 25 20 15 10 5 0 D S2 S S1 d l e yi d e t a ticip n A d l e yi ” “ yield ” er ath we “Bad Quantity (in bushels) B E NERGY P RICES $100 D2 D D1 90 80 70 60 50 40 30 Quantity (in barrels) The supply and demand curves are both inelastic. Panel A illustrates how a change in supply due to weather can cause a large change in food prices. Panel B shows that a large price change will also take place if there is a change in demand. Economic Analysis What would cause a change in the market demand for food? Change in Demand A change in demand, like a change in supply, can affect the price of a good or service. All of the factors we examined in Chapter 4—changes in income, tastes, prices of related products, expectations, and the number of consumers—affect the market demand for goods and services. One example is the demand for oil. In Panel B of Figure 6.3, a modest increase in demand, illustrated by a shift from D to D1, causes a large increase in the price. This is exactly what happened in 2005 and 2006 when economic growth in the U.S. economy and the rest of the world, especially China and India, increased the demand for energy. Because both the supply and the demand for oil are inelastic, the price of oil increased dramatically. On
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the other hand, if the world economy had declined instead, demand would have shifted to D2, bringing the price of oil down. Change in Supply and Demand In the real world, changes in both supply and demand often affect prices. For example, we know that strong economic growth in 2005 caused the demand curve for oil to increase (or shift to the right), which drove prices up. To make matters worse, hurricanes Katrina and Rita tore through the Gulf of Mexico, destroying and disabling hundreds of drilling platforms, refineries, and storage facilities. This caused the supply of oil to decrease (or shift to the left), driving the price of gasoline even higher. The resulting combination of increased demand and decreased supply gave the U.S. economy some of the highest energy prices it had seen since the 1970s. The Importance of Elasticity Whenever supply or demand for a product fluctuates, the elasticity of the two curves affects the size of the price change. To illustrate, both curves are relatively inelastic in Figure 6.3. If you look at Panel A, Michael Newman/PhotoEdit, Inc. you can see that the change in price is relatively large when supply changes. Panel B shows that the change in price is also large when demand shifts. If one or both curves are elastic, though, the change in price will be smaller. Fortunately, as we saw in Chapters 4 and 5, there are ways for us to determine the elasticity of both supply and demand. This means that we can predict how prices are likely to change if we know the elasticity of each curve and the underlying factors that cause the supply and demand curves to change. CAREERS Real Estate Agent The Work * Assist in renting, selling, and buying property for clients * Obtain listings (owner agreements to place properties for rent or sale), advertise the property, and show the property to prospective renters and buyers Qualifications * Knowledge of fair-market values, zoning laws, local land-use laws, housing and building codes, insurance coverage, mortgage and interest rates * Highly ambitious, flexible schedule, extensive social and business connections * High-school diploma, at least 18 years old, state real estate license * College courses in real estate, finance, business administra- tion, statistics, economics, law, and English helpful Earnings * Median annual earnings (including commissions): $35,670 Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 6 Prices and Decision Making 153 Competitive Markets In competitive markets, sellers need to
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adjust their prices to attract buyers. Why do economists like competitive marketsWell look at that! The store across the street has the same binoculars for $15 less.” Prices and Competitive Markets Economists like to see competitive markets because the price system is more efficient when markets are competitive. A perfectly competitive market requires a set of ideal conditions and outcomes that are seldom found in the real world, but fortunately markets don’t have to be perfect to be useful. As long as prices are allowed to adjust to new levels in response to the pressures exerted by surpluses and shortages, prices will perform their role as signals to both consumers and producers. The great advantage of competitive markets is that they allocate resources efficiently. As sellers compete to meet consumer demands, they are forced to lower the prices of their goods. This in turn encourages them to keep their costs down. At the same time, competition among buyers helps prevent prices from falling too far. In the final analysis, a competitive market economy is one that “runs itself.” There is no need for a bureaucracy, planning commission, or other agency to set prices, because the market tends to find its own equilibrium. In addition, the three basic economic questions of WHAT, HOW, and FOR WHOM to produce are decided by the participants— the buyers and sellers—in the market. Explaining How does the elasticity of a good affect its price? SECTION 2 Review Vocabulary 1. Explain the significance of economic model, equilibrium Critical Thinking 4. The BIG Idea Explain why competitive markets price, surplus, and shortage. allocate resources efficiently. Main Ideas 2. Determining Cause and Effect Use a graphic organizer like the one below to show how a change in demand or supply affects the price of a product. Demand/Supply r e a s e s I n c Price ________ / ________ Decreases Price ________ / ________ 3. Explaining How does the elasticity of supply and demand for a product affect the size of a price change? 5. Making Inferences What do merchants usually do to sell items that are overstocked? What does this tell you about the equilibrium price for the product? 6. Understanding Cause and Effect What will happen to the price you pay for concert tickets if a popular group has to move its show to a smaller facility? Why? 7. Analyzing Visuals Look at Figure 6.2 on p. 150. Create a graph showing what will happen at a price of $20. Applying Economics 8. Equilibrium
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Price Select a product that appears in newspaper ads of several different stores. Note the various prices and indicate whether any of these prices are sale prices. What does the information tell you about the equilibrium price of the product you selected? 154 UNIT 2 Microeconomics: Prices and Markets Jim Unger/Laughingstock Licensing NEWSCLIP The beauty of the supply and demand system lies in its ability to set prices. If demand is high and supply low, prices skyrocket and producers increase supplies. Simple, right? What happens, though, if suppliers are unable keep up with rapidly growing demand? What’s Raining on Solar’s Parade? The solar power industry has been on a tear, growing at more than 30% per year for the last six years. It’s poised to reach a surprising milestone within two years, when it will gobble up more silicon for its electricity-generating panels than semiconductor makers use in all their chips and devices.... So what’s the problem? “Global demand is stronger than the existing supply,” says Lee Edwards, president and CEO of BP Solar. His company and others can’t buy enough of the ultrapure polysilicon now used in 91% of solar panels. The raw material shortage has slashed growth for the industry from more than 50% in 2004 to a projected 5% in 2006. The shortage has caused prices for polysilicon to more than double over the last two years. As D EMAND AND P RICE OF S ILICON Demand for polysilicon in semiconductors Demand for polysilicon in solor photovolting Price of polysilicon 30 20 10 2003 Economics 101 teaches, that should prompt producers to expand capacity. But for suppliers such as Michigan-based Hemlock Semiconductor Corp., the world’s largest producer, the decision hasn’t been easy. For one thing, the company was badly burned in 1998. It had just built a new facility in response to pleas from semiconductor makers when Asia went into a slowdown. Demand for silicon plunged, and the factory had to be shuttered.... Hemlock finally decided that the industry is real, but only after solar companies agreed to share the risk by signing contracts to buy the future output. So in December the company began an expansion worth more than $400 million that will increase silicon production by 50%. Competitors are following suit. —Reprinted from BusinessWeek Examining the Newsclip
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$120 80 40 2004 2005† 2006 2007* 2008 1. Understanding Cause and Effect How did the Year shortage of polysilicon affect its price? Sources: Riper Jaffray, www.renewableenergyaccess.com * 2007 figure for price is estimated. † 2005–2008 figures for demand are estimated. 2. Analyzing Why was Hemlock Semiconductor Corp. at first reluctant to increase the production of polysilicon? Robert Harding Picture Library Ltd/Alamy CHAPTER 6 Prices and Decision Making 155 SECTION 3 Social Goals and Market Efficiency GUIDE TO READING Section Preview In this section, you will learn that governments sometimes use policies that interfere with the market in order to achieve social goals. Content Vocabulary • price ceiling (p. 157) • minimum wage (p. 158) • price floor (p. 158) • target price (p. 159) • nonrecourse loan (p. 159) • deficiency payment (p. 159) Academic Vocabulary • arbitrarily (p. 157) • stabilize (p. 159) Reading Strategy Explaining As you read the section, complete a cause-and-effect chart similar to the one below by explaining the effects of price ceilings and price floors. Policy Effects Price ceiling Price floor —The Washington Times ISSUES IN THE NEWS Minimum Wage Rise Hurts Students Maryland small business owners are bemoaning higher labor costs as the state’s minimum wage increases today from the federal threshold of $5.15 per hour to $6.15.... “A dollar an hour is a huge jump—people have no idea how that affects your payroll,” said Mike Kostinsky, who owns Sorrento of Arbutus, a pizza restaurant in Arbutus, Md.... Mr. Kostinsky, whose family has owned Sorrento for 41 years, said he typically adds four or five high school students at minimum wage during the summer to allow his 30 or so permanent employees to take vacations. As a result of the wage increase, “I won’t let anybody go, but I probably won’t hire anybody else,” he said. ■ In Chapter 2 we examined seven broad eco- nomic and social goals that most people seem to share. We also observed that these goals, while commendable, are sometimes in conflict with one another. These goals also have been partially responsible for the increased role that government plays in our
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economy. Attempts to achieve one of these goals—economic security—occasionally result in legislation such as the increase in the minimum wage in Maryland described in the news story above. While the legislation is clearly beneficial to some people, it can be detrimental to others. What is common to all of these situations, however, is that the outcome—wage control—can only be achieved by interfering with the price system and distorting the allocations made in the market. 156 UNIT 2 Microeconomics: Prices and Markets Robert W. Ginn/PhotoEdit, Inc. Distorting Market Outcomes MAIN Idea Price ceilings and price floors prevent prices from allocating goods and resources. Economics & You Do you think the minimum wage helps you or other people who are looking for jobs? Read on to learn how the minimum wage can affect the job market. One common way to achieve social goals is to have the government set prices at “socially desirable” levels. When this happens, prices are not allowed to adjust to their equilibrium levels, and the price system cannot transmit accurate information to other buyers and sellers in the market. Price Ceilings Some cities, especially New York City, have a long history of using rent controls to try to make housing more affordable. This is an example of a price ceiling, a maximum legal price that can be charged for a product. The case of a price ceiling is shown in Figure 6.4. Let us assume that without the ceiling, the market would establish monthly rents at $900, which is an equilibrium price because 2.0 million apartments would be supplied and rented at that rate. If authorities think $900 is too high, and if they want to achieve the social goals of equity and security for people who cannot afford these rents, they can arbitrarily establish a price ceiling at $600 a month. No doubt renters would love the lower price and might demand 2.4 million apartments. Landlords, on the other hand, would try to convert some apartments to other uses, such as condominiums and office buildings that offer higher returns. Therefore, the supply might only reach 1.6 million apartments at $600 per month, leaving a permanent shortage of 800,000 apartments. price ceiling highest legal price that can be charged for a product Are consumers better off? Perhaps not. More than likely, the better apartments will be converted to condos or offices—leaving the poorer ones to be rented. In addition, 800,000 people are now unhappy because they cannot get an apartment, although they are
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willing and able to pay for one. Prices no longer allocate apartments. Instead, landlords resort to long waiting lists or other nonprice criteria such as excluding children and pets to discourage applicants. Rent controls also freeze a landlord’s total revenue and threaten his or her profits. As a result, the landlord tries to lower costs by providing the absolute minimum upkeep. In addition, landlords have little incentive to add additional units if they feel rents are too low. Some apartment buildings may even be torn down to make way for shopping centers, factories, or high-rise office buildings. The price ceiling, like any other price, affects the allocation of resources—but not in the way intended. The attempt to limit rents makes some people happy, until their Figure 6.4 Price Ceilings P RICE C EILING S In housing markets, a rent control is a price ceiling1500 1200 900 600 300 0 Equilibrium price Price ceiling Shortage 1.6 2.0 2.4 Quantity (in millions) A price ceiling of $600 leaves 800,000 people permanently without apartments. Without the ceiling, an additional 400,000 people would have found an apartment at $900. Economic Analysis Why does government sometimes impose restrictions such as price ceilings on the market? minimum wage lowest legal wage that can be paid to most workers price floor lowest legal price that can be paid for a product buildings begin to deteriorate. Others, including landlords and potential renters on waiting lists, are unhappy from the beginning. Finally, some productive resources—those used to build and maintain apartments—slowly move out of the rental market. Price Floors Other prices are sometimes considered too low, so the government takes steps to keep them higher. The minimum wage, the lowest legal wage that can be paid to most workers, is such a case. The minimum wage in fact is a price floor, or lowest legal price that can be paid for a good or service. Figure 6.5 uses a minimum wage of $5.15 per hour as an illustration of a price floor. At this wage, the supply curve shows that 14 million people would want to offer their services. According to the demand curve for labor, however, only 10 million would be hired, leaving a surplus of 4 million workers without jobs. Figure 6.5 Price Floors P RICE F LOOR ) 8.00 6.00 5.15 4.00 2.00 0 Price floor Equilibrium price Surplus S In labor markets, a minimum wage is a price floor. D 10 14 Quantity
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(in millions) 12 At a price floor of $5.15 per hour, 10 million workers will be hired. At the equilibrium price of $4.00 per hour, 2 million more people would find jobs. Economic Analysis Who benefits from price floors? Who is placed at a disadvantage? 158 UNIT 2 Microeconomics: Prices and Markets The figure also shows that without the minimum wage, the actual demand and supply of labor would establish an equilibrium price of $4.00 per hour. At this wage, 12 million workers would offer their services and the same number would be hired—which means that there would be neither a shortage nor a surplus in the labor market. Most economists argue that the minimum wage actually increases the number of people who do not have jobs because employers hire fewer workers at higher wages. In the case of Figure 6.5, the number of people who lose jobs amounts to 2 million—the difference between the 12 million who would have worked at the equilibrium price and the 10 million who actually work at the higher wage of $5.15 per hour. Is the minimum wage good or bad for the economy? Certainly the minimum wage is not as efficient as a wage set by supply and demand, but not all decisions in our economy are made on the basis of efficiency. The basic argument in favor of the minimum wage is that it raises poor people’s incomes and provides a small measure of equity—one of our seven major economic and social goals. A federal minimum wage is evidence that the small measure of equity provided by the minimum wage is preferred to the loss of efficiency. Finally, it could be argued that the minimum wage is irrelevant because it is actually lower than the lowest wages paid in many areas. Consider the wages in your area, for example. More than likely, most employers pay wages higher than the minimum wage and would not lower them even if the minimum wage were eliminated. Do you think that your employer would pay you less if he or she were allowed to do so? Your response will provide a partial answer to the question. Reading Check Analyzing What are the negative and positive aspects of price ceilings and price floors? Agricultural Price Supports MAIN Idea Government programs to help stabilize prices for farmers have both positive and negative effects. Economics & You Do you remember learning in your history class about the plight of farmers during the Great Depression? Read on to find out how the government tried to help farmers. During the Great Depression of the 1930s, prices plummeted everywhere. Farmers, however, had an even more difficult
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time because they were having the “bumper yields” illustrated in Panel A of Figure 6.3 on page 152 that pushed prices even lower. Because both the demand for and supply of food were inelastic, farm prices fell much further than other prices in the economy. To help farmers, the federal government established the Commodity Credit Corporation (CCC), an agency in the Department of Agriculture. The CCC then used a target price, which is essentially a price floor, to help stabilize farm prices. Loan Supports Under one CCC support program, a farmer borrowed money from the CCC at the target price and pledged his or her crops as security in return. The farmer then used the loan to plant, maintain, and harvest the crops. When they were ready for harvest, the farmer had two choices: either sell the crop in the market and use the proceeds to repay the CCC loan, or keep the proceeds of the loan and let the CCC take possession of the crop. The farmer could get at least the target price because the loan was a nonrecourse loan—a loan that carries neither a penalty nor further obligation to repay if not paid back. Deficiency Payments While the CCC loan program helped farmers, it created new problems because the U.S. Department of Agriculture soon target price price floor for agricultural products set by the government to stabilize farm income nonrecourse loan agricultural loan that carries no penalty or further obligation if it is not repaid deficiency payment cash payment making up the difference between the market price and the target price owned enormous stockpiles of food. The deparment had to resort to storing surplus wheat in rented warehouses or on open ground. Surplus milk was made into cheese and stored in underground caves. The military received some of the food, while public schools received other food that they could use in their “free lunch” programs. Still the surpluses grew, leaving politicians to consider how they could support farm prices and avoid holding large surpluses at the same time. The solution was a new governmentprogram that combined the competitive market with price supports. Farmers sold their crops on the open market for the best price they could get based on demand and supply. The CCC then gave farmers a deficiency payment—a check the government sends to producers to make up the difference between the market price and the target price. Figure 6.6 Deficiency Payments D EFICIENCY P AYMENTS $6.00 5.00 4.00 3.00 2.00 1.00
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Target price Market price 0 2 4 S The farmer is paid the difference between the target and the market price. D 16 18 6 8 10 Quantity (in thousands of bushels) 12 14 Under the CCC deficiency payment program, a target price such as $4 per bushel of wheat was set. At this price farmers would produce and sell 10,000 bushels. With 10,000 bushels produced, buyers would pay $2.50 per bushel in the marketplace, so the CCC would need to give an additional payment of $1.50 per bushel to farmers to hit the target price. Economic Analysis How much would the farmer have produced and earned without the deficiency payment program very popular with farmers and today accounts for nearly 10 percent of total farm subsidies Federal Land Bank The government currently pays some farmers to not farm in an effort to reduce production and to support farm income. How much land is in the land bank program? “...and here I was... only just getting used to being paid for NOT doing things.” Conservation “Land Banks” The loan support and deficiency payment programs of the 1930s continued for several decades. By the 1980s, though, two factors combined to make these programs increasingly expensive to maintain. For one, agricultural output increased dramatically because of increased farm productivity. In addition, there were simply too many farmers involved in agriculture. Many experts concluded that the solution was to get some farmers to stop farming. The result was the Conservation Reserve Program of 1985 that paid farmers to not farm. To enroll in the program, acreage where crops previously grew was set aside in a “land bank” to save the land for future use. The U.S. Department of Agriculture would then pay the farmer an annual fee as long as the land was not farmed. While the program was expensive for taxpayers, it has since become 160 UNIT 2 Microeconomics: Prices and Markets McArthur, Bill/www.CartoonStock.com Reforming Price Supports In an effort to make farming responsive to the market forces of supply and demand, Congress passed the Federal Agricultural Improvement and Reform (FAIR) Act in 1996. Under FAIR, “loan rates” took the place of target prices, and temporary cash payments replaced price supports and deficiency payments. Lawmakers hoped that when the law expired, farmers would be experienced enough with the laws of supply and demand to no longer need help. However, the new payments turned out to be larger than the ones they
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replaced, and the overall cost of the U.S. farm support programs actually went up. Then, when FAIR was about to expire in 2002, Congress replaced it with the Farm Security and Rural Investment Act of 2002, which provided for even larger price support payments that would last through 2007. Continued Agricultural Support Today, American agriculture is more dependent than ever on subsidies and price supports. In addition to subsidizing basic commodities like rice, corn, sugar, and cotton, crops such as peanuts, sunflower seeds, and mohair are also covered. The amount of land that farmers are paid to not farm has grown to be larger than the state of New York. Whether this is good or bad depends on your perspective. If you are a taxpayer supplying the funds for these payments, you might think that the government spends too much on these programs. If you are a farmer receiving payments, you are probably glad that the government is supporting the goal of economic security. Reading Check Summarizing What has been the effect of agricultural price supports? When Markets Talk MAIN Idea Markets send signals when prices change in response to events. Economics & You Have you heard stories in the news about changes in the stock market when a new government policy was announced? Read on to find out how markets “talk.” buy gold. As a result, stock prices would fall, and the price of gold would rise. In a sense, the market would “talk” by voicing its disapproval of the new tax policy. Markets are impersonal mechanisms that bring buyers and sellers together. Although markets do not talk in the usual sense of the word, they do send signals in that they speak collectively for all of the buyers and sellers who trade in the markets. Markets are said to “talk” when prices in them move up or down significantly in reaction to events that take place elsewhere in the economy. Suppose federal government announced that it would raise taxes to pay off some of the federal debt. If investors thought this policy would not work or that other policies might be better, they might decide to sell some of their stocks and other investments to the In this example, individual investors made decisions on the likely outcome of the new policy and sold stocks for cash or gold. Together, investor actions were enough to influence stock prices and to send a signal to the government that investors did not favor the policy. If investors’ feelings were divided about the new policy, some would sell while others bought stocks. As a result, prices might not change, and the message
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would be that, as yet, the market had not made up its mind. Reading Check Examining Can you think of any other examples of markets “talking”? Explain. Fed Alert Stock markets react quickly to any major news report. One such report is a change in the interest rate charged by the Federal Reserve for loans. Eight times a year, the Fed takes a look at this rate. Stock market reaction is swift: If it likes the change, stock prices will go up that day. Prices will drop just as quickly if changes are unexpected or undesired. Skills Handbook See page R35 to learn about Identifying the Main Idea. SECTION 3 Review Vocabulary 1. Explain the significance of price ceiling, minimum wage, price floor, target price, nonrecourse loan, deficiency payment. Main Ideas 2. Determining Cause and Effect Use a graphic organizer like the one below to illustrate how price floors affect quantity demanded and supplied. Quantity demanded ___________ Price floor Quantity supplied ___________ 3. Explaining Why did the federal government establish agricultural price support programs? 4. Describing How do markets speak collectively for buyers and sellers? Critical Thinking 5. The BIG Idea Explain why a government would consider imposing a price ceiling or price floor. 6. Analyzing Visuals Look at Figure 6.4 on p. 157. How does the price ceiling affect the relationship between quantity supplied and quantity demanded? Why does the price ceiling make this relationship permanent? 7. Predicting What would happen if the government eliminated all farm subsidies? Applying Economics 8. Price Floor Interview 10 classmates who have part-time jobs. Identify where they work and who gets paid at, below, or above the federal minimum wage. Use that information to predict how increasing the federal minimum wage by $1.00 per hour would impact employment for teenagers in your area. CHAPTER 6 Prices and Decision Making 161 ENTREPRENEUR Profiles in Economics Margaret (Meg) Whitman (1956– ) • ranked by Fortune magazine as the “Most Powerful Woman in Business” in 2005 • turned eBay into one of the fastest-growing companies in U.S. history Excellence Leads eBay As president and CEO of eBay Inc. since 1998, Meg Whitman runs the world’s leading Internet auction site. Although eBay was invented by software engineer Pierre Omidyar in 1995, it has been Whitman’s leadership and branding expertise that made the site a household name. The year Whitman took over eBay, the company earned about $6 million
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. Seven years into her leadership, the company’s revenues grew to $4.6 billion. Her secret? She works quickly to fix problems, such as removing counterfeit items for auction and instituting PayPal to help streamline the payment process. She asks questions instead of issuing orders, and she shares what she learns with her employees. She also listens to customers and employees and seeks their feedback. The Power of All of Us Business analysts agree that Whitman’s success has more to do with her willingness to listen than anything else. As she says, “Our army of users figures out what’s hot before we even know.” That attitude keeps Whitman in the chat room instead of the boardroom. She reads hundreds of e-mails from users every day, and her “Voice of the Customer” program has been known to reverse business decisions based on user complaints. She trusts what she calls “The Power of All of Us” to sustain a community of users that will essentially guide itself. When eBay management thought car sales would be too complicated and risky, the eBay community demanded the capability. Because Whitman was open to the suggestion, more than 1 million cars have now been sold on eBay. If Meg Whitman were to have a feedback profile similar to the ones kept by the buyers and sellers on eBay, her rating would be high indeed. Examining the Profile 1. Summarizing What management techniques have made eBay so successful? 2. Drawing Conclusions Do you think Whitman’s philosophy of “The Power of All of Us” could work in other industries? Explain. When Meg Whitman became CEO, many of the items auctioned on eBay were small collectibles like Star Wars toys. Today eBay sells everything consumers demand. Says Whitman, “It is the users who build the company.” 162 UNIT 2 Microeconomics: Prices and Markets Kim Kulish/Corbis CHAPTER 6 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Allocation of Resources Prices are signals that help buyers and sellers make economic decisions. Without prices, societies must find other ways to allocate resources. With Prices: • Prices serve as link between producers and consumers • Allocation easy because prices are neutral, flexible, and have no cost Allocation of resources Without Prices: • Must find another system such as rationing • Allocation difficult because of problems with fairness, high cost of administration, and less incentive for people to work Market
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Equilibrium When buyers and sellers can freely make production and purchase decisions, the price of a product will move toward market equilibrium. At this point, the quantity supplied is exactly equal to the quantity demanded. M ARKET D EMAND AND S UPPLY C URVES e c i r P $30 25 20 15 10 5 0 S Equilibrium price 10 11 12 13 14 15 16 Quantity Social Goals and Prices The social goals of equity and security sometimes can be achieved only by giving up parts of other goals. Price ceilings or price floors can help achieve these goals, but they may result in fewer goods and services offered overall. P RICE C EILING P RICE F LOOR S In housing markets, a rent control is a price ceiling1500 1200 900 600 300 0 Equilibrium price Price ceiling Shortage 1.6 2.0 2.4 Quantity (in millions8.00 6.00 5.15 4.00 2.00 0 Price floor Equilibrium price Surplus S In labor markets, a minimum wage is a price floor. D 10 14 Quantity (in millions) 12 CHAPTER 6 Prices and Desicion Making 163 CHAPTER 6 Assessment & Activities Review Content Vocabulary Review the Main Ideas Use the terms below to identify the missing cause or effect in the following situations. a. rationing b. surplus c. shortage d. equilibrium price e. price ceiling f. price floor 1. Cause: The government tries to keep prices down by legislating a price ceiling. Effect: ______ 2. Cause: The government wants to allocate scarce goods and services without the help of a price system. Effect: ______ 3. Cause: A reasonably competitive market experiences brief, minor shortages and surpluses. Effect: ______ 4. Cause: ______ Effect: New York City has many apartments with very low rents but also has a shortage of apartment units. 5. Cause: A market is at equilibrium, but the product falls out of style before producers can reduce production. Effect: ______ 6. Cause: ______ Effect: Farmers receive higher prices for milk and cheese but also experience a surplus. Review Academic Vocabulary 7. Create the clues for the crossword puzzle below. Your Section 1 (pages 143–146) 8. Describe four advantages of using price as an allocating mechanism. 9. Discuss why allocating resources without prices is difficult. 10. Explain why prices are neutral. Section 2 (pages 148–154) 11. Explain what is meant by the term market equilibrium. 12. Describe the role of
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shortages and surpluses in competitive markets. 13. Identify three causes of a price change in a market, using a graphic organizer like the one below. Add examples and identify the possible results for each. Price changes Section 3 (pages 156–161) 14. Explain why shortages and surpluses are not temporary when price controls are used. clues should relate to the chapter content. 15. Identify and describe two of the programs that have been used to stabilize farm incomes. 16. Explain what is meant by the statement that “markets talk.” Critical Thinking 17. The BIG Idea Explain why and how a reasonably competitive market is always moving toward equilibrium. 18. Making Generalizations Some people argue that providing price supports to farmers is unfair to consumers. In a short paper, describe the positive and negative results of these price supports. Then explain why you support or oppose such programs. 164 UNIT 2 Microeconomics: Prices and Markets 19. Making Predictions Suppose that your state wanted to make health care more affordable for everyone. To do this, state legislators put a series of price controls— price ceilings—in place that cut the cost of medical services in half. In short paragraphs, explain your answers to the following questions: a. What would happen to the demand for medical services at the new, lower price? b. What would happen to the supply of medical services that doctors would be willing to provide at the new, lower price? c. What considerations would new doctors take into account when they decide where to set up their practice? Explain the reasons for your answers. 20. Synthesizing You were invited to speak to a middle school class about the activities available at your school. You brought 20 ballpoint pens with the high school logo, but there were 30 students in the class. What kind of nonprice rationing system would you devise to fairly allocate the scarce item? 21. Predicting Assume that the price of school lunches has become too high, and you need to set a price ceiling to remedy the problem. What would the consequences of such a policy be for both students and the school? Math Practice 22. A shoe store is having a sale. The first pair of shoes sells for $40. The second pair sells for half price, or $20. The next pair sells for half of that, and so on. Create a table like the one below that tracks the total cost of the shoes as each pair is added. Stop when the selling price of the last pair of shoes is less than
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$1.50. Number of pairs Total cost 1 Th Economics: Principles and Practices Web site at glencoe.com and click on Chapter 6—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Analyzing Visuals 23. Examine the figure below, then answer the questions that follow. P RICE A DJUSTMENT P ROCESS e c i r P $30 25 20 15 10 10 11 12 13 14 15 16 Quantity a. What is the quantity demanded at a price of $20? At $15? b. What is the quantity supplied at a price of $10? At a price of $20? c. How large is the shortage or surplus at $5? Explain your answer. d. If the price started at $5 today, what would likely happen to the price tomorrow? Why? Thinking Like an Economist 24. Economists like to use cost-benefit analysis to assess the merits of any program. Use this decision-making strategy to evaluate the desirability of continuing rent control. Write a paragraph describing your strategy and results. Writing About Economics 25. Persuasive Writing Research newspapers and news magazines for recent articles about the minimum wage. Using what you have learned about price floors and the information in the articles, decide whether you favor or oppose raising the minimum wage. Write a 2-page paper outlining your views. CHAPTER 6 Prices and Decision Making 165 DEBATES IN ECONOMICS Should College Athletes Be Paid? $ College athletes—particularly basketball and football players—rake in millions of dollars for their universities and the National Collegiate Athletic Association (NCAA). Some people argue that these athletes deserve to be compensated for their role in generating this revenue, whereas others maintain that free-ride scholarships and the potential to “go pro” are more than enough compensation. Can you sift through the debate to determine whether college athletes should receive more than a free college education for their efforts? As you read the selections, ask yourself: Should college athletes be paid? PRO COLLEGE ATHLETES SHOULD BE PAID Vince Young fakes the pass, pulls the ball down and runs for the game-winning touchdown in the national championship game. Those connected with Texas are smiling as one of the greatest players in its storied history has led the Longhorns to a national title. The higher-ups at the school had reason to smile much earlier... With the chance to claim a national title also came $
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3.5 million from the [Bowl Championship Series] directly to Texas and another $14.9 million distributed among the Big 12 conference teams. The problem is, the athletes who help schools and conferences make that money do not see a dime of it. They may receive scholarships, but so do students who don’t help the school make money in any way.... If schools can profit off of student athletes, why should those athletes not be paid for helping schools make money?... Paying [college athletes] would improve quality of play by keeping borderline professional athletes in college. Also, it would help those same players develop their skills so they could make more money at the professional level. $453,000,000 $13,000,000 NCAA REVENUES • CBS broadcast and marketing rights, including Division I men’s basketball tournament • ESPN broadcast rights for 21 championships, including Division I women’s basketball, baseball, ice hockey, and softball • Other broadcast rights • Division I men’s basketball tickets • Tickets for other Division I championships • Tickets for Division II and III championships • Investments, fees, and services • Membership dues —Andrew Zivic, writer for iMPrint Magazine $4,450,000 $27,870,000 $13,175,000 $705,000 $8,790,000 $1,010,000 Source: IndyStar.com, 2005–2006 NCAA Revenues 166 UNIT 2 Microeconomics: Prices and Markets Ronald Martinez/Getty Images CON COLLEGE ATHLETES SHOULD NOT BE PAID As my opening kick against this notion, please accept the obvious premise that college athletes do trade on their skill for financial gain. This gain is realized in the form of a scholarship.... Four (or five) years on a free ride at, say, the University of Michigan can cost a person well over 100,000 [dollars].... $129,435,000 $122,800,000 NCAA EXPENDITURES * The NCAA maintains that 95 percent of its money is returned to the membership via direct payments or event services. • Division I athletic departments and conferences • Division I conferences, based on performance in the men’s basketball tournament • Division I academic support; need-based emergency aid for players; “student-athlete opportunity fund” • Division I championships and other programs, including team travel and officials • Division II and III expenditures • Association-wide expenses
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, including insurance, enforcement, communications, and legal services • General administration • Legal contingencies; president’s reserve; endowment $55,357,000 $55,100,800 $39,411,000 $87,779,400 $22,836,800 $9,280,000 How much loot-gathering should be attributed to the play of [a] backup left guard? How about the second-string corner? Should there be a salary scale that bestows a stipend commensurate with the player’s productivity? What a hayride that would be to administrate.... Another problem with paying or subsidizing Source: IndyStar.com, 2005–2006 NCAA Revenues college athletes is the danger of tipping an already unbalanced playing surface. While it’s assumed that most Division I schools are rolling in dough, reality finds many athletic departments in the red. At more than a few schools, some of the low-revenue sports often are sacrificed. Schools with huge football revenues—such as Michigan, Texas, Ohio State, and USC—would have an even bigger advantage if paying players became an option. —Randy Hill, writer for FOXSports.com Analyzing the Issue 1.1. Identifying What are the arguments in favor of paying college athletes to play? 2. 2. Summarizing What reasons does Hill give against paying college athletes? 3. 3. Deciding With which opinion do you agree? Explain your reasoning. CHAPTER 6 Prices and Decision Making 167 Ronald Martinez/Getty Images CHAPTER 7 Market Structures Why It Matters A developer has acquired the large piece of vacant land across the street from your house and plans to build a large shopping mall on the property. How might you benefit from the mall? How might it negatively impact your life? Read Chapter 7 to learn about market structures and economic growth. The BIG Ideas 1. The profit motive acts as an incentive for people to produce and sell goods and services. 2. Economists look at a variety of factors to assess the growth and performance of a nation’s economy. 3. Governments strive for a balance between the costs and benefits of their economic policies to promote economic stability and growth. When many companies offer similar products, each firm tries to differentiate its goods to attract customers. 168 UNIT 2 Powerstock/Index Stock Imagery Economics: Principles and Practices Web site at glencoe.com and click on Chapter 7—Chapter Overviews to preview chapter information. Chapter
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Overview Visit the SECTION 1 Competition and Market Structures GUIDE TO READING Section Preview In this section, you will learn that market structures include perfect competition, monopolistic competition, oligopoly, and monopoly. Content Vocabulary • laissez-faire (p. 169) • market structure (p. 169) • perfect competition (p. 170) • imperfect competition (p. 172) • monopolistic competition (p. 173) • product differentiation (p. 173) • nonprice competition (p. 173) • oligopoly (p. 174) • collusion (p. 174) • price-fixing (p. 175) • monopoly (p. 175) • natural monopoly (p. 176) • economies of scale (p. 176) • geographic monopoly (p. 176) • technological monopoly (p. 176) • government monopoly (p. 177) Academic Vocabulary • theoretically (p. 170) • equate (p. 177) Reading Strategy Identifying As you read the section, complete a graphic organizer similar to the one below by identifying the characteristics of different market structures. Market Structure Characteristics Perfect competition ISSUES IN THE NEWS Profits, Prices Spur Oil Outrage —The Washington Post Exxon Mobil Corp. reported $8.4 billion in first-quarter profit yesterday, as members of Congress, outraged over high gasoline prices, hastened to propose measures that would boost taxes on oil firms, open new areas to drilling and provide rebates to taxpayers but would not necessarily alter prices at the pumps. “What you have today is an oligopoly, effectively, and I think it’s a disaster for the American people,” said Senator Dianne Feinstein. Federal Reserve Chairman Ben S. Bernanke cautioned Congress on the various proposals being floated. “I would like to let the market system work as much as possible to generate new supplies....” ■ When Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations in 1776, the average factory was small, and businesses were competitive. Laissez-faire, the French term that means “allow them to do,” was the prevailing philosophy that limited government’s role to protecting property, enforcing contracts, settling disputes, and protecting firms against foreign competition. Conditions are much different today. An industry, or the supply side of the market, has many firms of different sizes producing slightly different products. These conditions help determine market structure, or the nature and degree of competition among firms
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doing business in the same industry. Economists group firms into four different market structures that reflect the competitive conditions in those markets. laissez-faire philosophy that government should not interfere with business activities market structure nature and degree of competition among firms in the same industry The McGraw-Hill Companies CHAPTER 7 Market Structures 169 perfect competition market structure with many well-informed and independent buyers and sellers who exchange identical products Perfect Competition MAIN Idea Perfect competition is an ideal market situation used to evaluate other market structures. Economics & You You learned earlier about industries. Read on to find out how perfect competition is the ideal market structure in an industry. Perfect competition is a market structure characterized by a large number of wellinformed independent buyers and sellers who exchange identical products. It represents a theoretically ideal situation that is used to evaluate other market structures. In Perfect Competition A farmers’ market comes closest to satisfying the conditions for a perfectly competitive market. What conditions for perfect competition are met in this photograph, and how? order for a market to have perfect competition, it needs to meet five necessary conditions that other market structures lack. Necessary Conditions The first condition is that there must be a large number of buyers and sellers. No single buyer or seller is large enough or powerful enough to single-handedly affect the price. The second condition is that buyers and sellers deal in identical products. With no difference in the products, there is no need for brand names and no need to advertise, which keeps prices low. With no differences between products, one seller’s merchandise is just as good as another’s. The third condition is that each buyer and seller acts independently. This ensures that sellers compete against one another for the consumer’s dollar, and that consumers compete against one another to obtain the best price. The fourth condition is that buyers and sellers are reasonably well-informed about products and prices. Well-informed buyers shop at the stores that have the lowest prices. Well-informed sellers match the lowest prices of their competitors to avoid losing customers. The fifth condition is that buyers and sellers are free to enter into, conduct, or get out of business. This freedom makes it difficult for producers in any industry to keep the market to themselves. Producers have to keep prices competitive, or new firms can take away some of their business. Collectively, these conditions help ensure the competition that is necessary to keep prices low and quality high. Profit Maximization Under perfect competition, market supply and demand set the equilibrium price for the product. Because
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the price is determined in the market, and because each firm by itself is too small to influence the market price, the perfect competitor is often called 170 UNIT 2 Microeconomics: Prices and Markets Mika/zefa/Corbis Figure 7.1 Perfect Competition and Profit Maximization Under perfect competition, the market forces of supply and demand establish the equilibrium price. The perfectly competitive firm treats this price as its demand curve and its marginal revenue (MR) because the firm will receive $15 for each and every unit it sells. Economic Analysis What would happen to total profits if the firm used 10 workers instead of 9? A M ARKET B I NDIVIDUAL F IRM See StudentWorks™ Plus or glencoe.com. e c i r P $30 25 20 15 10 5 0 S Equilibrium market price D Profits are maximized where MR = MC MC Price = $15 = D = MR Additions to profit Subtractions from profit 22.50 10.00 4.74 4.50 Quantity 110 129 Quantity 138 144 148 a “price taker.” The firm then must find the level of output it can produce that will maximize its profits. To understand how this is done, it helps to examine Figure 7.1. This figure shows the relationship between the perfectly competitive firm and its industry. In Panel A, supply and demand set the equilibrium market price at $15 per unit of output. Because the firm in Panel B receives $15 for the first and every additional unit it sells, the market price is the same as the firm’s marginal revenue curve (MR). In order to show a graphical example, the firm in Figure 7.1 is the same one that appeared earlier in Figure 5.6 on page 134. While the number of workers are not shown in Figure 7.1, the total production, marginal cost, and marginal revenue are the same in both figures. When it comes to determining the profit maximizing quantity of output in Figure 7.1, the logic of marginal analysis is the same as before. For example, Panel B in the figure above tells us that the firm would make a profit on the 110th unit of output because it would only cost $4.50 to produce and could be sold for $15. As long as the marginal cost of producing one more unit of output is less than the marginal revenue from the sale of that output, the firm would continue to hire more workers and expand its output. Given its marginal cost and marginal revenue
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conditions, the firm shown in Figure 7.1 would find it profitable to hire enough workers to expand production until 144 units of output are produced. Of course, total output would continue to go up if the firm hired more workers and expanded production. However, total profits would start to go down because the marginal cost of production would then become increasingly larger than the $15 marginal revenue from sales. In the end, the profit maximizing quantity of output is found where the marginal cost of production is equal to the marginal revenue from sales, or where MC = MR. This occurs at 144 units of output. Other levels of output may generate equal profits, but none will generate more. CHAPTER 7 Market Structures 171 imperfect competition market structure that does not meet all conditions of perfect competition A Theoretical Situation Few perfectly competitive markets exist because it is difficult to satisfy all five necessary conditions. Local vegetable farming, sometimes called “truck” farming, comes close. In these markets many sellers offer nearly identical products. Individual sellers are generally unable to control prices, and both buyers and sellers have CAREERS Market Researcher The Work * Gather, record, and analyze facts about products and sales using company or government records, published materials, statistical files, and other sources * Print and circulate questionnaires or survey people over the phone or door-to-door to help companies forecast future sales trends, design new products, and develop advertising strategies Qualifications * Strong analytical and writing skills * Experience with computerized data * College courses in marketing, statistics, English composition, speech, psychology, and economics * Bachelor’s degree, with many positions requiring a master’s or Ph.D. Earnings * Median annual earnings: $53,810 Job Growth Outlook * Faster than average Source: Occupational Outlook Handbook, 2006–2007 Edition 172 UNIT 2 Microeconomics: Prices and Markets age fotostock/SuperStock reasonable knowledge of most products and prices. Finally, anyone who wants to enter the business by growing tomatoes, corn, or other products can easily do so. When markets are perfectly competitive, several things combine to keep prices low. For example, when everyone is dealing with identical products, there is no need to advertise, which keeps the cost down. Second, when the products that everyone sells are identical, there is no reason for one seller to charge a price higher than anyone else. If the seller does try to charge a higher price, buyers will simply go elsewhere. Third, if there are a large number of independent buyers and
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sellers, then no single buyer is big enough to push the price down and no single seller is big enough to force the price up. As a result, buyers will always try to purchase from the seller with the lowest price. Finally, if it is easy for sellers to enter or leave the market, then new sellers can always come in if they think they can make a profit. Likewise, sellers who cannot match the new competition are free to leave. Imperfect Competition Although perfect competition is rare, it is important because economists use it to evaluate other, less competitive, market structures. Imperfect competition is the name given to any of three market structures—monopolistic competition, oligopoly, and monopoly—that lacks one or more of the conditions required for perfect competition. Most firms and industries in the United States today fall into one of these categories. When we examine imperfect competition, we will see that it results in less competition, higher prices for consumers, and fewer products offered. This is why perfectly competitive markets are theoretically ideal situations that can be used to evaluate other market structures. Reading Check Describing Why does perfect competition serve as a theoretical market structure? Product Differentiation Monopolistic competitors must find ways to attract the attention of buyers. How does the advertisement on this billboard differentiate this product from other colas? monopolistic competition market structure that meets all conditions of perfect competition except identical products product differentiation real or imagined differences between competing products in the same industry nonprice competition sales strategy focusing on a product’s appearance, quality, or design rather than its price Monopolistic Competition MAIN Idea Monopolistic competition shares all the conditions of perfect competition except the same goods or services. Economics & You How many stores do you know that offer similar products? Read on to learn how this reflects monopolistic competition. Monopolistic competition is the market structure that has all the conditions of perfect competition except for identical products. Under monopolistic competition, products are generally similar and include things such as designer clothing, cosmetics, and shoes. The monopolistic aspect is the seller’s ability to raise the price within a narrow range. The competitive aspect is that if sellers raise or lower the price enough, customers will ignore minor differences and change brands. Product Differentiation Monopolistic competition is characterized by product differentiation—real or perceived differences between competing products in the same industry. Most items produced today—from the many brands of athletic footwear to personal computers— are differentiated. Nonprice Competition do this with nonprice competition—the use of advertising, giveaways, or
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other promotions designed to convince buyers that the product is somehow unique or fundamentally better than a competitor’s. In a monopolistically competitive industry, advertising is important. This explains why producers of designer clothes spend so much on advertising and promotion. If a seller can differentiate a product in the mind of the buyer, the firm may be able to raise the price above its competitors’ prices. Because advertising is expensive, it raises the cost of doing business for the monopolistic competitor, and hence the price the consumer pays. Profit Maximization The profit maximizing behavior of the monopolistic competitor is no different from that of other firms. The firm will expand its production until its marginal cost is equal to its marginal revenue, or where MC = MR. If the firm’s advertising convinces consumers that its product is better, then it can charge a higher price. If not, the firm must charge less. Finally, it is easy for firms to enter the monopolistically competitive industry. Each new firm makes a product only a little different from others on the market. The result is a large number of firms producing a variety of similar products. To make their products stand out, monopolistic competitors try to make consumers aware of product differences. They Reading Check Comparing How is profit maximization in a monopolistic firm different from that of a perfect competitor? Todd Gipstein/Corbis CHAPTER 7 Market Structures 173 &The Global Economy YOU Poco, Heart, and Wisdom If you invent a product, remember that an important part of selling it is the brand name. In the global economy, Western brands sometimes get lost in translation. The real genius in selling overseas is to capture foreign consumers’ attention with a Western product, but relate it to their lives and culture in a familiar way. PepsiCo, for example, sells its popular Lays potato chips in China. It also introduced a local brand of potato chips called Poco. In addition to changing the name of the chips, PepsiCo adjusted the flavor to satisfy local tastes. German carmaker Volkswagen used its slogan, “For the love of the automobile,” as a springboard for the Asian market. Savvy marketing gurus took this catchy slogan and attached it to the Chinese-language written character for heart. The VW brand campaign includes 16 total characters, including those for compassion, loyalty, and wisdom, and associates the characters with VW automobiles. The VW Golf model represents loyalty, for example, whereas the Passat is a blend of heart and goal. oligopoly market structure
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in which a few large sellers dominate the industry collusion agreement, usually illegal, among producers to fix prices, limit output, or divide markets Personal Finance Handbook See pages R30–R31 for more information on buying a car. Oligopoly MAIN Idea Oligopoly describes a market in which a few sellers dominate an industry. Economics & You What products can you think of that are sold by a small number of sellers? Read on to learn about oligopolies. Oligopoly is a market structure in which a few very large sellers dominate the industry. The product of an oligopolist may have distinct features, as do the many makes and models of cars in the auto industry; or it may be standardized, as in the steel industry. As a result, oligopoly is further from perfect competition than monopolistic competition. In the United States, many markets are already oligopolistic, and many more are becoming so. For example, Burger King, McDonald’s, and Wendy’s dominate the fast-food industry. A few large corporations control other industries, such as the domestic airline and automobile industries. Interdependent Behavior Because oligopolists are so large, whenever one firm acts, the other firms in the industry usually follow—or they run the risk of losing customers. For example, when Chrysler introduced the first minivan, other companies soon followed. The tendency of oligopolists to act together often shows up in their pricing behavior, such as copying a competitor’s price reduction in order to attract new customers. For example, if Ford or General Motors announces zero-interest financing or thousands of dollars back on each new car purchased, its competitors will match the promotion almost immediately. In extreme cases this can lead to a price war, or a series of price cuts that result in unusually low prices. Because oligopolists usually act together when it comes to changing prices, many firms prefer to compete on a nonprice basis by enhancing their products with new or different features. Automobile companies do this every year when they introduce models. If an oligopolist finds a way to enhance a product, its competitors are at a disadvantage for a period of time. After all, it takes longer to develop a new physical attribute for a product than it does to match a price cut. Sometimes the interdependent behavior takes the form of collusion, a formal agreement to set specific prices or to otherwise behave in a cooperative manner. One form 174 UNIT 2 Microeconomics: Prices and Markets AP Images price-fixing agreement, usually
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illegal, by firms to charge the same price for a product monopoly market structure with a single seller of a particular product of collusion is price-fixing, or agreeing to charge the same or similar prices for a product. In almost every case these prices are higher than those determined under competition. The firms also might agree to divide the market so that each is guaranteed to sell a certain amount. Because collusion usually restrains trade, it is against the law. Profit Maximization The oligopolist, like any other firm, maximizes its profits when it finds the quantity of output where its marginal cost is equal to its marginal revenue, or where MC = MR. The oligopolist will then charge the price consistent with this level of sales. Because of all the nonprice competition, the product’s final price is likely to be higher than it would be under monopolistic competition, and much higher than it would be under perfect competition. Nonprice competition is always expensive for a firm, and these expenses usually come back to the consumer in the form of higher prices. Reading Check Explaining Why do oligopolists frequently appear to act together? Monopoly MAIN Idea A monopoly is a market with only one seller for a particular product. Economics & You Did you ever play the game of Monopoly? Read on to learn how this game reflects the problems caused by having one seller in the market. At the opposite end of the spectrum from perfect competition is monopoly. A monopoly is a market structure with only one seller of a particular product. This situation—like that of perfect competition—is an extreme case. In fact, the American economy has very few, if any, cases of pure monopoly— although the local cable TV operator or telephone company may come close. Even the telephone company, however, faces competition from other communication companies, from the United States Postal Service, and from Internet providers that supply e-mail and telephone services. Local cable providers face competition from video rental stores, satellite cable systems, and the Internet. Consequently, when people talk about monopolies, they usually mean near-monopolies. Figure 7.2 Characteristics of Market Structures Number of firms in industry Many Many Few One Perfect competition Monopolistic competition Oligopoly Pure monopoly Influence over price Product differentiation Advertising Entry into market Examples None None None Limited Some Fair amount Fair amount Extensive None Fair amount Some None Easy Easy Difficult Almost impossible Perfect: None Near: Truck farming Gas stations Women’s clothing Automobiles Aluminum Perfect: None Near: Water The term
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market structure refers to the nature and degree of competition among firms operating in the same industry. Individual market structures, listed on the left, are determined by the five characteristics listed in the columns above. Economic Analysis In which market structure does nonprice competition play a major role? Public utility companies fall into this category because it would be wasteful to duplicate the networks of pipes and wires that distribute water, gas, and electricity throughout a city. To avoid these problems, the government often gives a public utility company a franchise—the exclusive right to do business in a certain area without competition. By accepting such franchises, the companies also accept a certain amount of government regulation. The justification for the natural monopoly is that a larger firm can often use its personnel, equipment, and plant more efficiently. This results in economies of scale, a situation in which the average cost of production falls as the firm gets larger. When this happens, it makes sense for the firm to be as large as is necessary to lower its production costs. Sometimes a monopoly exists because of a specific location. A drugstore operating in a town too small to support two or more such businesses becomes a geographic monopoly. This is a monopoly based on the absence of other sellers in a certain geographic area. Similarly, the owner of the only gas station on a lonely interstate highway exit also has a type of geographic monopoly. A technological monopoly is a monopoly that is based on ownership or control of a manufacturing method, process, or other scientific advance. The government may grant a patent—an exclusive right to manufacture, use, or sell any new and useful invention for a specific period—to the inventor. Inventions are covered for 20 years; however, a product’s design can be patented for shorter periods, after which it becomes public property available for the benefit of all. Art and literary works are protected through Monopolies A geographic monopoly exists when there is only one seller of a product in a particular area. What would indicate that this gas station has a geographic monopoly? natural monopoly market structure where average costs of production are lowest when a single firm exists economies of scale situation in which the average cost of production falls as a firm gets larger geographic monopoly market structure in which one firm has a monopoly in a geographic area technological monopoly monopoly based on a firm’s ownership or control of a production method, process, or other scientific advance We have few monopolies today because Americans traditionally have disliked them and have tried to outlaw them. Another reason is that new technologies often introduce products that compete with existing monopolies.
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The development of the fax machine allowed businesses to send electronic letters that competed with the U.S. Postal Service. Later, e-mail became even more popular than the fax. Today, telephone service over the Internet is yet another technology challenging phone monopolies. Types of Monopolies Sometimes the nature of a good or service dictates that society would be served best by a monopoly. A natural monopoly—a market situation where the costs of production are minimized by having a single firm produce the product—is one such case. Natural monopolies often can provide services more cheaply than several competing firms could. For example, two or more competing telephone companies serving the same area would be inefficient if each company needed its own telephone poles and lines. 176 UNIT 2 Microeconomics: Prices and Markets Ric Ergenbright/Corbis government monopoly a monopoly owned and operated by the government Skills Handbook See page R41 to learn about Drawing Conclusions. a copyright—the exclusive right of authors or artists to publish, sell, or reproduce their work for their lifetime plus 50 years. Still another kind of monopoly is the government monopoly—a monopoly owned and operated by the government. Government monopolies are found at all three levels of government—national, state, and local. In most cases they involve products or services that private industry cannot adequately supply. Many towns and cities have monopolies that oversee water use. Some states control alcoholic beverages by requiring that they be sold only through state stores. The federal government controls the processing of weapons-grade uranium for military and national security purposes. Profit Maximization Monopolies maximize profits the same way other firms do: they equate marginal cost with marginal revenue to find the profit-maximizing quantity of output. Even so, there are differences between the monopolist and other profit-maximizing firms—especially the perfect competitor. First, the monopolist is much larger than the perfect competitor. This is because there is only one firm—the monopolist—supplying the product, rather than thousands of smaller ones. Second, both because of its large size and the lack of meaningful competition, the monopolist is able to behave as a “price maker.” This differs from the perfect competitor, who faces competition and is a price taker. Because there are no competing firms in the industry, there is no equilibrium price facing the monopolist. In order for the monopolist to maximize its profits, it will do exactly as all the other firms have done: it will equate MC with MR because this method always shows
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the level of output that produces the highest total profits. The result will be a very high price—higher than would be charged under conditions of perfect competition, monopolistic competition, or oligopoly. Reading Check Analyzing Why do natural monopolies sometimes result in economies of scale? SECTION 1 Review Vocabulary 1. Explain the significance of laissez-faire, market structure, perfect competition, imperfect competition, monopolistic competition, product differentiation, nonprice competition, oligopoly, collusion, price-fixing, monopoly, natural monopoly, economies of scale, geographic monopoly, technological monopoly, and government monopoly. Main Ideas 2. Explaining Why is the perfect competitor often called a “price taker”? 3. Identifying Use a graphic organizer like the one below to identify the characteristics of imperfect competition. Critical Thinking 4. The BIG Idea Describe the four basic market structures and explain how they differ from one another. 5. Differentiating Which characteristics of firms selling designer clothing are monopolistic? Which are competitive? Write a brief paragraph explaining your answer. 6. Inferring If Americans traditionally dislike monopolies, why do some monopolies exist today? What types of monopolies are they, and what are their characteristics? 7. Analyzing Visuals Compare the photos of the farmers on page 170 and the gas station on page 176. How do market conditions differ for these sellers? Imperfect Competition Applying Economics 8. Product Differentiation Search your local newspaper for local clothing stores ads. You should find at least two different ads. Describe how the advertisements succeed or fail to differentiate the products. CHAPTER 7 Market Structures 177 ENTREPRENEUR Profiles in Economics Bill Gates (1955– ) • co-founder and chairman of Microsoft Corporation • ranked the richest man in the world for 12 years in a row Early Start Bill Gates was not the first computer geek, but he was probably the most passionate. In high school, he designed a class-scheduling program so that he could take courses with the prettiest girls in his school. He also started Traf-O-Data, a computer traffic analysis company. At Harvard University, he and his friend Paul Allen wrote an operating-system language that they licensed to a computer manufacturer. With this early success, at age 19 Gates dropped out of Harvard and, with Allen, established Microsoft Corporation in 1975. Five years later, computer industry giant IBM asked Gates to develop an operating system for its new personal computer. Gates modified a system he had bought from a small
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company and called it MS-DOS, for Microsoft Disk Operating System. Gates decided to license rather than sell it to IBM. This allowed him to market MS-DOS to other companies. By 1993 Microsoft’s Windows operating system ran nearly 90 percent of the world’s PCs. Gates and the Average Computer User Much of Gates’s success came from understanding the needs of average computer users. His software encompasses a range of programs integrated to work together seamlessly for everyday users and businesses. Gates made sure that all programs were written to be user-friendly to make computing fun. As a result, computers became accessible to non-techies worldwide. Gates is also known for his business stance. “He expects energy and commitment from his employees,” said one Microsoft employee. “He insists on a thoughtful, thorough, complete analysis.” Even Gates admits his tenacity. “In the early days, I liked to review every line of code, to interview every job applicant,” he said. “I’ve had to lighten up in both of those areas.” Examining the Profile 1. Analyzing What characteristics made Gates a successful entrepreneur? 2. Predicting Consequences How might the Microsoft story have been different if Gates had sold MS-DOS to IBM rather than licensing it? Personal computers had appeared in the marketplace by 1975, but they were still a novelty. Many people saw them as science fiction gadgets from the set of Star Trek. But Seattle teenagers Bill Gates and Paul Allen had a vision to “put a computer on every desktop and in every home.” 178 UNIT 2 Microeconomics: Prices and Markets Getty Images SECTION 2 Market Failures GUIDE TO READING Section Preview In this section, you will find out that inadequate competition, inadequate information, immobile resources, public goods, and externalities can lead to market failures. Academic Vocabulary • collude (p. 180) • sustain (p. 181) Reading Strategy Content Vocabulary • market failure (p. 180) • public goods (p. 181) • externality (p. 181) • negative externality (p. 182) • positive externality (p. 182) Listing As you read the section, think about why maintaining adequate competition is a worthwhile goal. Use a graphic organizer like the one below to list some of the effects of competition. If markets are competitive... Effects —USA Today COMPANIES IN THE NEWS Enron A federal
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judge in Houston sentenced Richard Causey, former chief accounting officer of Enron, to 5 1/2 years in prison Wednesday, bringing an end to the government’s prosecution of top managers at what was once the nation’s seventh-largest company.... Enron collapsed into bankruptcy five years ago after acknowledging that [Andrew] Fastow, the CFO, had entered into numerous business deals with the company that helped prop up Enron’s earnings. Fastow later admitted that he embezzled close to $30 million from the company. Enron’s market capitalization, which at one point exceeded $60 billion, was wiped out in the ensuing sell-off of stock. In January 2002, the Department of Justice formed the Enron Task Force. Since then, prosecutors induced 16 former executives to plead guilty to related crimes, while several others were convicted at trial.... [W]ith Causey’s sentencing, the last of the big Enron cases has been disposed of. ■ The story about Enron reminds us of a serious fact of economic life—that markets sometimes fail. In fact, the Enron scandal was not the only accounting scandal dominating the news in the early 2000s. WorldCom, a telecommunications company, had to declare bankruptcy in 2002 amid charges of breaking the law. These news stories showed clearly that a competitive free enterprise economy works best when several conditions, including adequate information, are met. If we want to avoid problems like this in the future, we need to be able to identify and then deal with different types of market failures. AP Images CHAPTER 7 Market Structures 179 market failure condition that causes a competitive market to fail Types of Market Failures MAIN Idea Markets can sometimes fail because of inadequate competition, inadequate information, resource immobility, public goods, and externalities. Economics & You Have you ever been affected by something that somebody did to another person? Read on to learn how this can also happen in the economy. Unfortunately markets sometimes fail. A market failure occurs whenever one of the conditions necessary for competitive markets does not exist. As you will learn, five main causes of market failures exist. Inadequate Competition Over time, mergers and acquisitions result in larger and fewer firms dominating various industries. The decrease in competition tends to reduce the efficient use of scarce resources—resources that could be put to other, more productive uses if they were available. For example, why would a firm with few or no competitors have the incentive to use
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its resources carefully? Inadequate competition can occur on both the demand and supply sides of the market. If we consider the supply side of the market, there is no competition when a monopolist dominates. In an oligopolistic market, the temptation to collude is strong. Expensive Memories The first law to fight monopolies, the Sherman Antitrust Act, was enacted in 1890 as a response to growing concern over the power of trusts. Enforcement was left to the courts, and judges considered the language of the act too vague to make big companies change the way they did business. As a result, the number of trusts increased following passage of the act. It took another 14 years before the first major lawsuit, Northern Securities v. the United States, was filed. Laws have become stronger since then, but price collusion still is a problem. In May 2006 three computer memory chip manufacturers were accused of fixing prices over a three-year period. This increased the price of chips for computer manufacturers, and thus the price of computers for consumers. The chipmakers agreed to pay $160 million to settle the case. 180 UNIT 2 Microeconomics: Prices and Markets If we look at the demand side of the market, there is little or no competition if the government is the only buyer for space shuttles, hydroelectric dams, super computers, M-1 tanks, or high-technology fighter jets. A firm that does not face adequate competition could easily spend its profits on huge salaries and bonuses, executive jets, country club memberships, and generous retirement plans. This is one of the reasons that public utilities such as electricity are regulated by the government—to make sure that the firms do not use their monopoly status to waste or abuse resources. Inadequate competition also may enable a business to influence politicians in order to get special treatment that enriches its managers and owners. In fact, some of the players in the huge Enron energy scandal were accused of doing just that—lobbying administration and Energy Department officials for favorable treatment on policy issues that benefited Enron executives. Inadequate Information If resources are to be allocated efficiently, everyone—consumers, businesspeople, and government officials—must have adequate information about market conditions. A secretary or an accountant may receive a competitive wage in the automobile industry, but wages for the same skills might be higher in the insurance or banking industry. Some information is easy to find in the classified ads in the newspaper or on the Internet. Other information is more difficult to find. If this knowledge
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is important to buyers and sellers but is difficult to obtain, then it is an example of a market failure. The consequences of inadequate information may not always be immediately visible, but in the long run it will put a slow drain on the economy, lowering the rate of growth and the overall standard of living. Resource Immobility A difficult problem in any economy is that of resource immobility. This means that land, capital, labor, and entrepreneurs Public Goods Funding floodwalls is expensive, but failing to keep up with maintenance can have catastrophic results, as the photo of New Orleans after Hurricane Katrina shows. Why does the market not provide more public goods? public goods goods or services whose benefits are available to everyone and are paid for collectively externality economic side effect that affects an uninvolved third party do not move to markets where returns are the highest. Instead they tend to stay put and sometimes remain unemployed. What happens, for example, when a large auto assembly plant, steel mill, or mine closes, leaving hundreds of workers without employment? Certainly some workers can find jobs in other industries, but not all can. Some of the newly unemployed may not be able to sell their homes. Others may not want to move away from friends and relatives to find new jobs in other cities. Public Goods Another form of market failure shows up in the form of public goods. Public goods are products that are collectively consumed by everyone. Their use by one individual does not diminish the satisfaction or value available to others. Examples of public goods are uncrowded highways, floodcontrol measures, national defense, and police and fire protection. When left to itself, the market either does not supply these items at all, or it supplies them inadequately. This is because a market economy produces only those items that can be withheld if people refuse to pay for them. It would be difficult, for example, to deny one person the benefits of national defense while supplying it to others. Because it is so difficult to have all individuals pay for their fair share of a public good, private markets produce too few of them. In the aftermath of Hurricane Katrina, it was evident that the floodwalls in New Orleans could not sustain the onslaught of the hurricane. Floodwalls are public goods that are normally funded out of government expenditures; they are not built by the private sector because there is little profit to be gained by building them. A related problem is that government does not always see the need to spend tax dollars on public goods. In the case of the floodwalls, it
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was all too easy to postpone the necessary expenditures because they would have resulted in higher taxes or in not building other public goods. Externalities Many activities generate some kind of externality, or unintended side effect that either benefits or harms a third party not involved in the activity that caused it. Smiley N. Pool/Dallas Morning News/Corbis CHAPTER 7 Market Structures 181 Externalities Air pollution is a negative externality that affects those who did not cause it. How can government action lead to the cleanup of pollution? negative externality harmful side effect that affects an uninvolved third party positive externality beneficial side effect that affects an uninvolved third party A negative externality is the harm, cost, or inconvenience suffered by a third party because of actions by others. The classic case of a negative externality is the noise and inconvenience some people suffer when an airport expands. A positive externality is a benefit someone receives who was not involved in the activity that generated the benefit. For example, people living on the other side of town may benefit from the additional jobs generated by the airport expansion, or a nearby restaurant may sell more meals and hire more workers. Both the restaurant owners and the new workers gain from the airport expansion even though they had nothing to do with the expansion in the first place. Externalities are market failures because their costs and benefits are not reflected in the market prices that buyers and sellers pay. For example, airlines do not compensate homeowners for the diminished value of properties located near a new runway extension. Nor does a restaurant owner share any additional profits with the airport. As a result, the prices that travelers pay for air travel will not reflect the external costs and benefits that an airport expansion generates. Reading Check Analyzing What type of market failure do you think is most harmful to the economy? Dealing with Externalities MAIN Idea Externalities indicate a market failure and can be corrected with government action. Economics & You Have you ever been affected by someone else’s pollution? Read on to learn how this can be remedied. The problem with externalities is that they distort the decisions made by consumers and producers. Overall this makes the economy less efficient. Correcting Negative Externalities A classic example of pollution sheds some light on the distortions caused by negative externalities. Firms historically located near rivers because transportation was convenient. However, the firms also used the rivers as a giant waste disposal system, which helped keep their production cost low. This led to lower market prices for the final product, and
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consumers were able to buy more. The negative externality of pollution generated several problems. Firms had the incentive to pollute because it was the most profitable way to produce. The low prices also encouraged more sales, and hence 182 UNIT 2 Microeconomics: Prices and Markets Steve Starr/Corbis more pollution. Finally, people living downstream from the polluting firms were, in effect, paying for some of the production costs even if they did not necessarily buy the products. Suppose the government decided to force the firms to clean up their pollution by putting a $1 “pollution tax” on every unit of output sold. The firms, of course, would try to pass some of this expense on to the consumer in the form of higher prices. While higher prices might at first seem to be a problem, they would force the people who bought the products to pay for the increase in production costs. The tax would help alleviate pollution problems. First, all firms would have less incentive to pollute because the tax drives up the price of their products. Second, higher prices would reduce the quantity demanded, so firms would produce less and therefore generate less pollution. Third, the people living downstream of the affected rivers would face less pollution. Correcting Positive Externalities Externalities can be positive as well as negative. You have learned that negative externalities lead to distortions. Yet even when externalities are positive, so that uninvolved third parties experience beneficial side effects, distortions can occur. A classic example is education. We know that people generally earn more when they have more education. In addition, a community with a well-educated workforce will attract more industry, have more economic development, and enjoy a higher standard of living. For these and other reasons, it makes sense for the government to subsidize the cost of public education. This is exactly what happens when local governments pay for the cost of primary and secondary public education. When it comes to the higher education offered by state universities, however, state governments only pay for part of the cost, leaving students to pick up the rest in the form of tuition payments. Given education’s value to the community, many experts feel that the government subsidies should be larger than they are. This is expensive, however, so government tends to underfund higher education even though more subsidies are warranted. Reading Check Explaining If externalities are positive, why should they be corrected? SECTION 2 Review Vocabulary 1. Explain the significance of market failure, public goods, externality, negative externality
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, and positive externality. Critical Thinking 4. The BIG Idea List and explain the reasons why markets fail. Main Ideas 2. Explaining Why do markets need both adequate competition and adequate information? 3. Identifying Use a graphic organizer like the one below to identify and describe both types of externalities. 5. Understanding Cause and Effect Describe some of the positive and negative externalities that could result from the closing of a military base. 6. Making Inferences Under what circumstances would a private firm be willing to build private toll roads? EXTERNALITIES Positive: Negative: Applying Economics 7. Negative Externality Identify a situation in your com- munity that resulted in a negative externality. How would you advise the government to reduce these negative effects? Write a short paper outlining your suggestions. CHAPTER 7 Market Structures 183 NEWSCLIP In 1984 concerns over a telecommunications monopoly led to the breakup of AT&T into eight different companies. Just a little over 20 years later, AT&T mergers seem to recreate the former corporation. When such mergers result in larger and fewer firms dominating an industry, some economists worry. Lord of the Rings Competition in communications seems cutthroat. Companies are invading each other’s turf, and prices are falling. You can make a video-phone call to Australia via the Internet, chat for three hours, and never pay a penny. Citing all this hubbub, AT&T Inc. argues that there’s no threat of remonopolization even as it bids to reunite five of the eight companies that emerged from the 1984 breakup of the Bell System. Look out, though. The competition we’re seeing is just a phase, and an unstable one at that. The key thing about communications networks is that they’re very costly to build, but once they’re built, it’s cheap to add customers to them. This industry structure has special economic properties. At times it produces price wars. At other times it leads to merger waves, resulting in a small number of competitors with the ability to raise prices and garner big profits.... Fragile Competition Communications companies may be shifting strategies from battling to consolidating. Strategy 1 Strategy 2 Price War Companies need lots of traffic to cover the costs of their expensive networks, so they cut prices. That forces other companies to reciprocate. Eventually profits vanish. Merger Wave Companies merge, with the strong buying the weak. As competition diminishes, profits rise
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. This strategy is more desirable to the companies, but may be banned by regulators. 184 UNIT 2 Microeconomics: Prices and Markets Getty Images In this delicate situation, [communications companies] have used two main strategies over the years. One has been to cut prices to fill up their networks. Remember, additional customers are cheap to serve, so there’s room to cut.... The alternative strategy, which [the CEO of AT&T] and others have also pursued, is consolidation. As long as regulators permit, the strong buy the weak and extinguish the excess capacity. As competition eases, the survivors can raise prices and restore their profitability. (Good for shareholders; bad for customers.) —Reprinted from BusinessWeek Examining the Newsclip 1. Summarizing What two strategies has AT&T used in recent years to gain new business, and why? 2. Determining Cause and Effect How does lack of competition increase prices for the consumer? SECTION 3 The Role of Government GUIDE TO READING Section Preview Reading Strategy In this section, you will learn that one of the economic functions of government in a market economy is to maintain competition. Describing As you read the section, complete a graphic organizer like the one below by describing how governments try to avoid market failures. Content Vocabulary • trust (p. 186) • price discrimination (p. 186) • cease and desist order (p. 186) • public disclosure (p. 188) Academic Vocabulary • restrained (p. 186) • intervention (p. 189) Government in Economic Affairs PRODUCTS IN THE NEWS Electric Bass Recalled —www.cpsc.gov The U.S. Consumer Product Safety Commission, in cooperation with Hoshino USA Inc., of Bensalem, Pa., and Chesbro Music Company, of Idaho Falls, Idaho, today announced a voluntary recall of about 700 Ibanez basses. If the battery is improperly installed, the bass can overheat, causing internal damage and a fire hazard. The firm has received three reports of the bass not working due to improper battery installation. There have been no reports of injuries or property damage. This recall involves 2005 and 2006 Ibanez Soundgear, Roadgear and Gary Willis series basses. Model numbers are located on the back of the headstock. Consumers should stop using the basses immediately and contact their local Ibanez dealer for a free inspection and repair. Dealers will remedy the hazard by having affected basses updated with a
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new battery snap connector. ■ We know that resources are scarce, and because of scarce resources we have to make careful choices if we are to satisfy our many wants and needs. We also know that competitive markets are one of the best ways to make this happen. At the same time, markets can fail. When they do, the government can step in and fix the problem. One way in which the federal government acts is by protecting the public from unreasonable risks of serious injury or death. For that task, it created the U.S. Consumer Product Safety Commission (CPSC), which oversees the safety of more than 15,000 types of consumer products. When necessary, the CPSC orders a recall of products for repair or replacement, as in the news story. Corbis CHAPTER 7 Market Structures 185 trust illegal combination of corporations or companies organized to hinder competition price discrimination practice of selling the same product at different prices to different buyers cease and desist order ruling requiring a company to stop an unfair business practice that reduces or limits competition Maintain Competition MAIN Idea The government exercises its power to maintain competition within markets. Economics & You When you play sports, a referee regulates the game to make sure both sides are playing fairly. Read on to learn how the government can regulate the economy to do the same thing. There are two ways that government can maintain competitive markets. One is by prohibiting market structures that are not competitive. The other is by regulating markets where full competition is not possible. Antitrust Legislation In the late 1800s, the United States passed laws to restrict monopolies and trusts— combinations of firms designed to restrict competition or control prices in a particular Figure 7.3 Anti-Monopoly Legislation Sherman Antitrust Act 1890 Clayton Antitrust Act 1914 Outlawed all contracts “in restraint of trade” to halt the growth of trusts and monopolies Strengthened the Sherman Act by outlawing price discrimination Federal Trade Commission Act 1914 Established the Federal Trade Commission to regulate unfair methods of competition in interstate commerce Robinson-Patman Act 1936 Forbade rebates and discounts on the sale of goods to large buyers unless the rebates and discounts were available to all The federal government passed four major legislative acts to curb monopolistic practices. Economic Analysis What is the purpose of the Federal Trade Commission? industry. Since then, several laws have been passed that allow the government to either prevent or break up monopolies and trusts, thus preventing market failures due to inadequate competition. In 1890 Congress passed the Sherman Antitrust Act �
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�to protect trade and commerce against unlawful restraint and monopoly.” The Sherman Act, described in Figure 7.3, was the nation’s first significant law against monopolies. It sought to do away with monopolies and restraints that hindered competition. By the early 1900s, a number of businesses, including the Standard Oil Company, had been convicted of restraint of trade under the Sherman Act. The Sherman Act laid down broad foundations for maintaining competition. However, the act was not specific enough to stop many other practices that restrained competition. As a result, Congress passed the Clayton Antitrust Act in 1914 to give the government more power over monopolies. This outlawed price discrimination— the practice of selling the same product to different consumers at different prices if it substantially lessens competition. The Federal Trade Commission Act was passed in the same year to enforce the Clayton Antitrust Act. The act set up the Federal Trade Commission (FTC) and gave it the authority to issue cease and desist orders. A cease and desist order is an FTC ruling requiring a company to stop an unfair business practice, such as price-fixing, that reduces or limits competition among firms. In 1936 Congress passed the RobinsonPatman Act in an effort to strengthen the Clayton Act, particularly the provisions that dealt with price discrimination. Under this act, companies could no longer offer special discounts to some customers while denying them to others. Government Regulation Not all monopolies are bad, and for that reason not all should be broken up. In the case of a natural monopoly, it makes sense to let the firm expand to take advantage of lower production costs, and then regulate its activities so that it cannot take advantage of the consumer. Local and state governments regulate many monopolies, such as cable television companies, and water and electric utilities. For example, if a public utility wants to raise rates, it must argue its case before a public utility commission or other government agency. Agencies of the federal government, such as those listed in Figure 7.4, regulate many different kinds of businesses. However, as you can see from the dates in the figure, in recent years the government has been less inclined to set up new regulatory bodies. Instead, the emphasis has shifted to promoting efficiency. Reading Check Describing Why are some government regulations beneficial for consumers? Skills Handbook See page R37 to learn about Making Generalizations. Figure 7.4 Federal Regulatory Agencies Agency Food and Drug Administration (FDA), 1906 Federal Trade Commission (FTC), 1914 Federal Communications
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Commission (FCC), 1934 Securities and Exchange Commission (SEC), 1934 National Labor Relations Board (NLRB), 1935 Federal Aviation Administration (FAA), 1958 Tasks Enforces laws to ensure purity, effectiveness, and truthful labeling of food, drugs, and cosmetics; inspects production and shipment of these products Administers antitrust laws forbidding unfair competition, price fixing, and other deceptive practices Licenses and regulates radio and television stations and regulates interstate telephone and telegraph rates and services Regulates and supervises the sale of listed and unlisted securities and the brokers, dealers, and bankers who sell them Administers federal labor-management relations laws; settles labor disputes; prevents unfair labor practices Oversees the airline industry Equal Employment Opportunity Commission (EEOC), 1964 Investigates and rules on charges of discrimination by employers and labor unions Environmental Protection Agency (EPA), 1970 Protects and enhances the environment Occupational Safety and Health Administration (OSHA), 1970 Investigates accidents in the workplace; enforces regulations to protect employees at work Consumer Product Safety Commission (CPSC), 1972 Nuclear Regulatory Commission (NRC), 1974 Federal Energy Regulatory Commission (FERC), 1977 Develops standards of safety for consumer goods Regulates civilian use of nuclear materials and facilities Supervises transmission of various forms of energy The government has created a number of federal regulatory agencies to oversee the economy. Because of government’s involvement in the economy, we have a modified free enterprise system. Economic Analysis Which agencies listed in the table are familiar to you? Which affect you directly? Why? CHAPTER 7 Market Structures 187 public disclosure requirement that a business reveal information about its products or its operations to the public Personal Finance Handbook See page R14-R15 for more information on loans. Improve Economic Efficiency MAIN Idea Providing public goods and promoting transparency can improve economic efficiency. Economics & You Can you name some public goods in your community? Read on to learn why public goods must be provided by the public sector. Fortunately, the government has the ability to correct two market failures that interfere with competitive markets: inadequate information and public goods. Promote Transparency Efficient and competitive markets need adequate information. Transparency is a term used to indicate that information and actions are not hidden and instead are easily available for review. Public disclosure, the requirement that businesses reveal certain information to the public, is an important way to do this. For example, all corporations that sell stock to the public must disclose financial and operating information on a regular basis to both their shareholders and the Securities and Exchange Commission (SEC). This data
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is stored in a free database that can be accessed by anyone on the Internet. Disclosure requirements also exist for consumer lending. If you obtain a credit card or borrow money to buy a car, the lender will explain in writing the method for computing the monthly interest, the length of the loan, the size of the payments, and other lending terms. This is not an act of kindness on the lender’s part because federal law requires these disclosures. Finally, “truth-in-advertising” laws prevent sellers from making false claims about their products. Most government documents, studies, and reports are available on the Internet. This includes the annual budget of the U.S. government, the Statistical Abstract of the United States, Census Bureau reports, and nearly every other publication that you can find in the government documents section of your local public library. Transparency Governments require disclosure to prevent companies from providing mis leading information. What requirements protect you as a borrower? “This isn’t rocket science, folks. One, we substitute code words for substantive ideology. Two, we create misleading advertising. Three, we issue bold pronouncements on phony profit margins. It’s all right here in the corporate training manual.” 188 UNIT 2 Microeconomics: Prices and Markets www.CartoonStock.com. Provide Public Goods A free enterprise economy does not produce public goods in sufficient quantity because such efforts usually do not result in direct financial gain. This means that many of the things society values—good roads and highways, museums and libraries, and education—must be provided by government. Public goods are important because they make the economy more productive. For example, businesses need reliable transportation so that they can move their raw materials and final products. In addition, their employees need to be able to easily communite to and from work. Firms also need an educated workforce that is both productive and able to purchase the products that are produced. Reading Check Interpreting What negative things could happen in a market without disclosure? Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 7—Student Web Activities for an activity on the government’s role in promoting fair business practices. Skills Handbook See page R45 to learn about Synthesizing Information. Modified Free Enterprise MAIN Idea Because the government is involved in certain aspects of our economy, it is a modified version of free enterprise. Economics & You What role does government play in your life? Read on to learn why some government
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regulation is desirable. The U.S. economy has changed dramatically over the years. One of the outcomes of this evolution is the rise of the modified free enterprise economy. In the late 1800s, the freedom to pursue self-interests led some people to seek economic gain at the expense of others. Under the label of competition, many larger firms used their power to take advantage of smaller ones. In some markets, less competitive market structures such as monopoly replaced competition, and the economy became less efficient. Because of these developments, Congress passed laws to prevent “evil monopolies” and to protect the rights of workers. It also passed food and drug laws to protect people from false claims and harmful products. Even public utilities faced significant government regulation to prevent the price gouging of consumers. Collectively, these actions have resulted in a modification of free enterprise. More recently, concern has shifted to economic efficiency and the role of the government in promoting it. Markets have become increasingly important, and we recognize that markets can fail in several different ways. When this happens, the government can take steps to remedy the situation. In addition to occasional interventions to keep markets reasonably competitive, the government can make the economy more efficient by supplying public goods and promoting transparency. People will continue to debate the proper role of government, but it turns out that markets alone cannot provide all of our wants and needs. Over the years, government’s role in the economy has slowly evolved from concern over consumer protection to the promotion of economic competition and efficiency. As a result of this government intervention, we now have a modified private enterprise economy, or an economy based on markets with varying degrees of government regulation. Reading Check Summarizing Why do we use the term modified to describe the American free enterprise economy? SECTION 3 Review Vocabulary 1. Explain the significance of trust, price discrimination, Critical Thinking 4. The BIG Idea Why is the government involved in cease and desist order, and public disclosure. economic affairs? Main Ideas 2. Identifying Use a graphic organizer similar to the one below to identify how the federal government can maintain competition and improve economic efficiency. 5. Making Inferences Why do governments regulate monopolistic cable companies and not prohibit them? 6. Synthesizing Information Identify at least two instances where you have personally benefited from government regulations. Explain the benefits. Action Antitrust legislation Purpose Applying Economics 3. Explaining Why is the United States considered to have a modified free enterprise economy? 7. Public Disclosure Obtain literature describing the computation of interest and
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conditions for withdrawal on various savings accounts from a local bank. Summarize the information in a short paragraph. Why do you think the bank is so forthcoming with this information? CHAPTER 7 Market Structures 189 CASE STUDY Pixar and Disney Birth of Pixar The short, happy tale of Pixar began when John Lasseter left Walt Disney studios in 1984 to join Lucasfilm, Ltd. Two years later, Steve Jobs, CEO of Apple Computer Inc., bought the computer graphics division of Lucasfilm for $10 million and renamed it Pixar. After winning numerous awards for short films and commercials, Pixar, with just 44 employees, teamed up with mega-studio Disney in 1991 to coproduce major films. D ISNEY S TOCK P RICES, 1995–2006 140 120 100 80 60 40 e c i r P 20 0 1995 1997 1999 2001 2003 2005 Year Disney’s management hoped to boost its stock price and remedy the sometimes tumultuous relationship between Disney and Pixar by entering into merger negotiations. Animation Merger By that time, Pixar had grown to a company of hundreds of employees, and federal regulatory authorities reviewed the merger for possible antitrust problems.The two companies finally merged in 2006 when Disney paid $7.5 billion for Pixar. As hoped, the price of Disney stock started to increase. A few months later, Cars zoomed into theaters, bringing in more than $60 million its first weekend. If you think stock prices follow ticket sales, though, think again. Despite that impressive showing, Disney’s stock fell slightly when the movie missed its $70 million goal. Analyzing the Impact 1. Summarizing How did Disney expect to gain from the merger with Pixar? 2. Drawing Conclusions Why might federal regulators be concerned about the merger of these two movie companies? Box Office Magic, Stock Ticker Woes Toy Story, the first collaboration by Disney and Pixar, was a box office home run, earning $358 million in box office receipts around the world as the highestgrossing film of 1995. B OX O FFICE RECEIPTS Toy Story $358.1 million A Bug’s Life Toy Story 2 $357.9 million $485.7 million Monster’s Inc. $528.9 million Finding Nemo $865.0 million The Incredibles $624.0 million Cars $367.6 million (and counting) The dynamic duo produced six more commercial hits, but Disney’s other work did not please moviegoers. Nor did its
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stock price satisfy stockholders. 190 UNIT 2 Microeconomics: Prices and Markets Photofest/Disney/Pixar CHAPTER 7 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Market Structures We can differentiate among four different market structures. One is called perfect competition; the other three are different kinds of imperfect competition. P ERFEC T C OMPETITION I MPERFEC T C OMPETITION Perfect Competition Monopolistic Competition Oligopoly Monopoly Large number of well-informed independent buyers and sellers who freely exchange identical products Has all characteristics of perfect competition except product differentiation A few very large sellers dominate the industry Only one seller for a particular product Market Failures When one of the conditions necessary for competitive markets does not exist, market failures can occur. Markets usually fail because of five factors. Inadequate competition Inadequate information Market Failures Resource immobility Need for public goods Externalities Government Roles In order to carry out its legal and social obligations, the government can encourage competition and regulate monopolies. Government Roles Restrict monopolies that hinder competition Regulate monopolies that provide services Provide public disclosure to prevent market failures CHAPTER 7 Market Structures 191 CHAPTER 7 Assessment & Activities Review Content Vocabulary Section 2 (pages 179–183) Use all of the terms below to write a paragraph about each of the four types of markets. Underline the terms within your paragraphs. 1. market failure 2. geographic monopoly 3. imperfect competition 4. monopolistic competition 5. natural monopoly 6. oligopoly 7. product differentiation 8. trust 9. price-fixing 10. nonprice competition Review Academic Vocabulary Use each of these terms in a sentence that reflects the term’s meaning in the chapter. 11. theoretically 12. equate 13. collude 14. sustain 15. restrained 16. intervention Review the Main Ideas Section 1 (pages 169–177) 17. Explain why perfect competition is a theoretical situation. 18. Describe the four types of monopolies by using a graphic organizer similar to the one below. 19. Explain what happens when markets do not have enough competition. 20. Describe what is meant by externalities. 21. Explain why the private sector is reluctant to produce public goods. Section 3 (pages 185–189) 22. Identify the purpose of antitrust legislation. 23. Explain how public disclosure is used as a tool to prevent market failures. 24. Describe the characteristics that make
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the U.S. economy a “modified free enterprise” economy. Critical Thinking 25. The BIG Idea Why does the federal government attempt to preserve competition among business enterprises? What different methods does the government have available for this task? 26. Making Inferences Do you think there would be any advantages to making monopolies or near monopolies break up into smaller, competing firms? Explain your answer. 27. Comparing and Contrasting Why are monopolies faced with more government regulations than other market structures? 28. Making Generalizations To what extent do you think government should be involved in the free enterprise economy? Defend your answer. Type of Monopoly Description Analyzing Visuals 29. Look at Figure 7.2 on page 175. Analyze the columns labeled “Influence over price” and “Entry into market.” How do the various types of market structures influence the results, and why? Present your answer and reasons in a short paragraph. 192 UNIT 2 Microeconomics: Prices and Markets Economics: Principles and Practices Web site at glencoe.com and click on Chapter 7—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Math Practice 30. The table below shows the price, market demand, market supply, and the surplus and shortage for a firm providing a product under perfect competition. Study the information in the table, and then answer the questions below. Thinking Like an Economist 32. Profit Maximization Economists like to analyze decisions incrementally, taking small steps and analyzing the costs and benefits of the steps as they are made. How is this way of thinking similar to the profit maximization logic illustrated in Figure 7.1 on page 171? Price 10 9 8 7 6 5 4 3 2 Market demand Market supply Surplus/ Shortage 600 ---- 850 990 ---- 1300 1470 1650 1840 1550 1500 1450 1400 1350 ---- ---- 1200 1150 950 780 ---- ---- 210 0 –220 ---- –690 a. Some of the information is missing from the table. Calculate the correct information. b. What is the equilibrium price? How can you tell? c. What price(s) will produce a surplus? d. What price(s) will produce a shortage? Applying Economic Concepts 31. Product Differentiation Choose a product offered by several producers that is advertised in newspapers or magazines. Then follow the steps below: a. Clip and save at least three different advertisements. b. In a journal, evaluate each advertisement and
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write why you would or would not buy a particular brand. c. Based on the evaluations, develop an advertisement for a product of your choice. d. Present your ad to the class and have other stu- dents evaluate how effectively you were able to differentiate your product from that of “competitors.” www.CartoonStock.com Writing About Economics 33. Expository Writing Select any five of the regulatory agencies described in Figure 7.4 on page 187 that relate directly to you. Write a short essay that discusses these agencies and evaluates whether they have a positive or negative effect on your life. Interpreting Cartoons 34. Critical Thinking Look at the cartoon below. What does the cartoon imply about monopolies? What can the government do to prevent such business practicesFreddie, the Little Merger Mogul, didn’t expect to have a monopoly right away. He planned to start small by rigging markets, restraining trade, and suppressing competition—then...” ’ CHAPTER 7 Market Structures 193 UNIT 3 Economic Institutions and Issues CHAPTER 8 Employment, Labor, and Wages CHAPTER 9 Sources of Government Revenue CHAPTER 10 Government Spending CHAPTER 11 Financial Markets Congress approves the federal budget, while the executive branch administers revenue collection and spending. 194 UNIT 3 (tl) Elizabeth Simpson/Getty Images, Larry Lee Photography/Corbis Larry Lee Photography/Corbis CHAPTER 8 Employment, Labor, and Wages Why It Matters Yesterday you found out that your first college choice has accepted you and offered you a scholarship to cover your tuition and books. You will still have to pay for your room and board. Today, your best friend announced that she has received a “full ride” basketball scholarship to the same college— all her expenses will be covered. Why do you think she received a larger scholarship even though your grades are much better than hers? Read Chapter 8 to find out more about labor and wages. The BIG Idea The labor market, like other markets, is determined by supply and demand. The more skills workers such as these construction workers have, the more they can expect to be paid. 196 UNIT 3 David Sailors/Corbis Economics: Principles and Practices Web site at glencoe.com and click on Chapter 8—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 The Labor Movement GUIDE TO READING Section Preview In this section, you will find out that labor unions are organizations that attempt to improve the working conditions of
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their members. Content Vocabulary • Great Depression (p. 201) • right-to-work law (p. 202) • craft union (p. 199) • trade union (p. 199) • industrial union (p. 199) • independent union (p. 203) • strike (p. 199) • picket (p. 199) • boycott (p. 199) • lockout (p. 199) • company union (p. 199) • closed shop (p. 203) • union shop (p. 204) • modified union shop • agency shop (p. 204) • civilian labor force (p. 204) (p. 204) Academic Vocabulary • legislation (p. 198) • prohibited (p. 201) Reading Strategy Sequencing As you read this section, note major events in the history of the U.S. labor movement by creating a time line similar to the one below. 1788 New York City Printers join to demand higher pay—first attempt to organize labor 1750 1800 1850 1900 1950 2000 —The Associated Press ISSUES IN THE NEWS Restaurant Fined over Youth Program Alex Ray, owner of the Common Man restaurants, has been fined by the government for a program that helped a dozen teenagers start and run their own business last summer. Ray paid a $2,000 fine after the Labor Department said the program violated child-labor laws. The teenagers, ages 13 to 15, worked at the Common Man Restaurant in Plymouth [New Hampshire], where they designed a business model, managed the business, scheduled fellow students to staff breakfast and made bank deposits. Ray said the project through a program called Communities for Alcohol- and Drug-Free Youth was a huge success, but the Labor Department sent a violation notice, because kids under 16 worked before 7 a.m. ■ The restaurant owner in the news article did not intend to violate the Fair Labor Standards Act of 1938, but good intentions sometimes have unforeseen consequences. Even so, working is one of the single most important things we do. After all, how well we do, as measured by the satisfaction we get or the income we receive, affects virtually every aspect of our lives. Thus, in our study of economics it is important to examine the way the “labor” factor of production earns its income. We also want to study the labor movement because the United States has a rich and colorful labor history. The historical struggle between workers and employers has shaped today’s working environment, and the evolution is
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still continuing. Jeff Cadge/Getty Images CHAPTER 8 Employment, Labor, and Wages 197 Skills Handbook See page R52 to learn about Sequencing Events. Colonial Times to the 1930s MAIN Idea Early unions formed to negotiate terms for their members, but employers and courts opposed them. Economics & You Do you or any members of your family belong to a union? Read on to learn about the early years of the American union movement. Today, only one out of every eight working Americans is a member of a labor union. Even so, unions are important because they played a major historical role in helping to create the legislation that affects our pay and working conditions today. Early Union Development In 1778 printers in New York City joined together to demand higher pay. This was the first attempt to organize labor in America. Before long, unions of shoemakers, carpenters, and tailors developed, each hoping to negotiate agreements that covered hours, pay, and working conditions. While only a small fraction of all workers belonged to unions, most unions were comprised of skilled workers and possessed strong bargaining power. Until about 1820, most of America’s workforce was made up of farmers, small business owners, and the self-employed. Soon immigrants began to arrive in great numbers. Because they provided a supply of cheap, unskilled labor, they posed a threat to the unions that were working to preserve existing wage and labor standards. In addition, public opinion was largely against union activity, and some parts of the country even banned labor unions. Labor organizers often were viewed as troublemakers, and many workers believed they could better negotiate with their employers on a one-to-one basis. Civil War to the 1930s The Civil War led to higher prices and a greater demand for goods and services. Manufacturing expanded, and the farm population declined. Hourly workers in industrial jobs made up about one-fourth of the country’s working population. Working conditions in some industries were difficult, and hostile attitudes toward unions slowly began to soften. Many of the cultural and linguistic differences between immigrants and American-born workers began to fade, and the labor force became more unified. Types of Unions In the industrial post–Civil War period, the two main types of labor unions shown in Figure 8.1 dominated. The first was the Figure 8.1 Trade (Craft) and Industrial Unions T RADE (C RAFT) U NIONS I NDUSTRIAL U NIONS Printers’ union Electricians’ union Machin
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ists’ union Carpenters’ union Plumbers’ union All belong to the same union Labor unions can be categorized as either trade or industrial unions. Economic Analysis How do trade unions differ from industrial unions? Labor Strikes This woodcut shows workers and firefighters during the Baltimore and Ohio Railroad strike of 1877. What did unions try to accomplish with strikes? craft union or trade union, an association of skilled workers who perform the same kind of work. The Cigar Makers’ Union, begun by union leader Samuel Gompers, is an example of this type of union. The second type of union was the industrial union— an association of all workers in the same industry, regardless of the job each individual worker performs. The development of basic mass-production industries such as steel and textiles provided the opportunity to organize this kind of union. Because many of the workers in these industries were unskilled and could not join trade unions, they organized as industrial unions instead. Union Activities Unions tried to help workers by negotiating for higher pay, job security, and better hours and working conditions. If an agreement could not be reached, workers would strike, or refuse to work until certain demands were met. Unions also pressured employers by having the striking workers picket, or parade in front of the employer’s business carrying signs about the dispute. The signs might ask other workers not to seek jobs with the company, or they might ask customers and suppliers to show union support by taking their business elsewhere. If striking and picketing did not force a settlement of the dispute, a union could organize a boycott—a mass refusal to buy products from targeted employers or companies. When a boycott was effective, it hurt the company’s business. Employer Resistance Employers resented the strikes, pickets, and boycotts, so they fought unions in a number of ways. Sometimes the owners called for a lockout, a refusal to let employees work until they agreed to management demands. At other times, management responded to a strike, or the threat of a strike, by hiring all new workers. Some owners even set up company unions—unions organized, supported, or run by employers—to head off efforts by others to organize workers. The Ludlow Massacre Perhaps nothing typified such struggles more than a strike in Colorado. The United Mine Workers of America had organized a strike against a mining company owned by craft union or trade union labor union whose members perform the same kind of work industrial union labor union whose members perform different kinds of work
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in the same industry strike union organized work stoppage designed to make an employer meet union demands picket demonstrate or march before a place of business to protest a company’s actions boycott refusal to buy products from an employer or company lockout management refusal to let employees work until demands are met company union union organized, supported, or run by an employer Bettmann/Corbis CHAPTER 8 Employment, Labor, and Wages 199 John D. Rockefeller to demand better pay and working conditions. When the company forced workers out of companyowned homes, the miners and their families moved into tents set up by the union. The strike, expected to end after a few days, instead lasted 14 months. At times, fights broke out between striking miners and company guards. The mining company also hired a private detective agency and received assistance from the Colorado National Guard. One fight in spring 1914 turned into an all-day battle and a devastating fire. In the end, dozens of people were killed, including 2 women and 11 children. The violence, quickly called the Ludlow massacre, sparked rioting in other coal mining communities. The resulting conflict eventually claimed nearly 200 lives. Attitude of the Courts Throughout this period, the courts had an unfavorable attitude toward unions. Under English common law, unions were considered conspiracies against business and were prosecuted in the United States. Even the Sherman Antitrust Act of 1890, aimed mainly at curbing monopolies, was used to keep labor in line. For example, in 1902 the United Hatters Union called a strike against a Danbury, Connecticut, hat manufacturer that had rejected a union demand. The union decided to apply pressure on stores to not stock hats made by the Danbury firm. The hat manufacturer, charging a conspiracy in restraint of trade under the Sherman Act, filed a damage suit that went all the way to the Supreme Court. The Supreme Court ruled that the union had organized an illegal boycott in restraint of trade, thereby dealing a severe blow to organized labor. The Danbury Hatters case and several subsequent antiunion decisions pushed organized labor to call for relief. The passage of the Clayton Antitrust Act of 1914 helped to remedy the threat to unions by expressly exempting labor unions from prosecution under the Sherman Act. Reading Check Recalling How did trade unions and industrial unions develop? Antiunion Attitudes A nationwide strike on May 3, 1886, turned violent in Chicago’s Haymarket Square when strikers and police clashed. How did the Supreme Court view union activity? 200 UNIT 3 Economic Institutions and Issues Bett
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mann/Corbis Unemployment During the Great Depression, the unemployed lined up for food and other assistance. What was the impact of the Great Depression on the labor movement? Labor Since the 1930s MAIN Idea Most of the significant labor laws in effect today were passed in the 1930s, 1940s, and 1950s. Economics & You Did you try to find a job before you turned 16 but were turned down? Read to learn how early labor legislation affects you today. During the 1930s, times were especially hard for working people who lacked unemployment insurance. In response, Congress passed a series of laws that supported organized labor. Although a backlash against labor followed, these laws provided the most important labor protections that are still in effect today. Labor in the Great Depression The Great Depression—the worst period of economic decline and stagnation in the history of the United States—began with the collapse of the stock market in October 1929. Economic output reached bottom in 1933 and did not recover to its 1929 level until 1939. At times, as many as one in four workers was without a job. Others kept their jobs but saw pay cuts. In 1929 the average hourly manufacturing wage was 55 cents. By 1933 it plummeted to 5 cents. Bettmann/Corbis The Great Depression brought misery to millions, but it also changed attitudes toward the labor movement. Common problems united factory workers, and union promoters renewed their efforts to organize workers. Great Depression worst period of economic decline in U.S. history, lasting from 1929 to approximately 1939 Pro-Union Legislation New legislation soon aided labor. The Norris-LaGuardia Act of 1932 prevented federal courts from issuing rulings against unions engaged in peaceful strikes, picketing, or boycotts. This forced companies to negotiate directly with their unions during labor disputes. The National Labor Relations Act, or Wagner Act, of 1935 established the right of unions to collective bargaining. The act also created the National Labor Relations Board (NLRB), giving it the power to police unfair labor practices. The NLRB also could oversee and certify union election results. If a fair election resulted in a union as the employees’ bargaining agent, employers had to recognize and negotiate with it. The Fair Labor Standards Act of 1938 applied to businesses that engage in interstate commerce and set the first minimum wage. It established time-and-a-half pay for overtime, which was defined as more than 40 hours per week. The act also prohibited CHAPTER 8 Employment, Labor, and Wages 201 Figure 8.2 Right-to-Work, State
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by State Today, 22 states have right-to-work laws that limit the power of unions. If a state has such a law, unions cannot force workers to join the union as a condition of continued employment. Economic Analysis Which regions have the fewest states with right-to-work laws? AK HI WA OR NV CA MT WY ID UT CO AZ NM States with right-to-work laws States without right-to-work laws Source: National Right to Work Commitee, 2006 ND SD NE MN IA KS MO OK TX AR LA NH VT ME NY PA VA NC WV MA RI CT NJ DE MD WI MI IN OH IL KY TN MS AL GA SC FL right- to- work law state law making it illegal to require a worker to join a union oppressive child labor, which includes any labor for a child under 16 and work that is hazardous to the health of a child under 18. Antiunion Backlash The union movement had grown strong by the end of World War II, but then public opinion shifted again. Some people feared that Communists had secretly entered the unions. Others were concerned over production losses due to the increased number of strikes. People began to think that management, not labor, was the victim. Growing antiunion feelings led to the Labor-Management Relations Act, or TaftHartley Act, of 1947. The act had a tough anti union provision known as Section 14(b) that allows individual states to pass rightto-work laws. A right-to-work law is a state law making it illegal to force workers to join a union as a condition of employment, even though a union may already exist. If a state does not have a right-to-work law, new workers may be required to join an 202 UNIT 3 Economic Institutions and Issues existing union as a condition for employment shortly after being hired. If a state has a rightto-work law, then new hires can decide for themselves whether or not they want to join the union—even if the overwhelming majority of workers at the company support the union. Today, the 22 states shown in Figure 8.2 have taken advantage of Section 14(b) to pass right-to-work laws. Other legislation was aimed at stopping criminal influences that had begun to emerge in the labor movement. The most important law was the Labor-Management Reporting and Disclosure Act, or LandrumGriffin Act, of 1959. This act required unions to file regular financial reports with the government and limited the amount of money union officials could
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borrow from the union. The AFL-CIO The American Federation of Labor (AFL) began in 1886 as an organization of craft or trade unions. It later added several industrial unions. The craft and industrial unions, however, did not always agree over the future of the union movement. As a result, eight of the AFL industrial unions formed a separate group headed by John L. Lewis, the president of the United Mine Workers of America. The AFL and Lewis did not get along, so Lewis and his industrial unions were expelled in 1937 and formed the Congress of Industrial Organizations (CIO). The CIO quickly set up unions in industries that had not been unionized before, such as the steel and automobile industries. By the 1940s, the CIO had nearly 7 million members. As the CIO grew stronger, it began to challenge the dominance of the AFL. In 1955 the AFL and the CIO joined to form the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO). In 2005, a disagreement over the best way to spend union funds resulted in a breakup of the AFL-CIO. Initially, the Service Employees International Union (SEIU), the largest union in the federation, left with several other large unions to form the rival Change to Win Coalition. Other unions soon followed, leaving the labor movement split for the first time since 1955. It is still too early to tell how this split will affect the power of organized labor. The remaining AFL-CIO unions want to focus their efforts on lobbying politicians. The Change to Win Coalition wants to focus its efforts on recruiting new union members. Independent Unions Although the AFL-CIO is still a major force, other unions are also important in the labor movement. Many of these are independent unions—unions that do not belong to the AFL-CIO or the Change to Win Coalition—such as the Brotherhood of Locomotive Engineers. Other examples of independent unions are the United Campus Workers at the University of Tennessee and the Virginia Public Service Workers Union. Reading Check Analyzing Why did the Great Depression have such a strong and lasting impact on the labor movement? Organized Labor Today MAIN Idea Unionized workers can participate in several types of union arrangements. Economics & You Have you ever noticed “Union Made” labels on clothing or other items? Read on to learn more about the different kinds of unions that make these products. Unionized workers participate in several kinds of union arrangements. In addition, union participation in the labor force varies widely from one
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industry to another. Kinds of Union Arrangements The most restrictive kind of union arrangement is the closed shop, in which an employer agrees to hire only union members. In effect, this allows the union to determine who is hired by giving or denying a person union membership. In some cases, union members could get family members and friends hired as long as the union controlled membership access, which most employers strongly opposed. This kind of union arrangement was common in the 1930s and early 1940s. However, the Taft-Hartley Act of 1947 made the closed shop illegal for all companies involved in interstate commerce. Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 8— Student Web Activities for an activity on labor unions. independent union labor union not affiliated with the AFL-CIO or the Change to Win Coalition closed shop arrangement under which workers must join a union before they are hired Power of Unions While unions remain a strong force, their bargaining power often is limited by economic conditions. What recent event may change the power of unions? REAL LIFE ADVENTURES © 2005 GarLanco. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. CHAPTER 8 Employment, Labor, and Wages 203 REAL LIFE ADVENTURES © 2005 GarLanco. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. &The Global Economy YOU The Union Safety Net Unravels If you have a part-time job, you are part of the reason that unions have declined. But don’t blame yourself—other factors are causing this trend as well. In fact, union membership has declined both in the United States and around the globe. In 2005, 12.5 percent of American wage and salary workers were union members, down from the most recent peak of 20.1 percent in 1983. Although union membership is higher in Europe— 26.3 percent—experts predict the downward trend to continue there as well, with union membership falling under 20 percent by 2010. Many factors have contributed to the decline of unions, including the increase in part-time workers, the rise in the number of women in the workforce, the growth in the number of white-collar workers, and the expansion of service industries. In addition, the trend toward smaller workplaces has hurt unionization. EU’ S F OUR L ARGEST C OUNTRIES —P ERCENTAGE OF U NION W ORKERS
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40% 30 20 10 0 Italy United Kingdom Germany France Countries United States Sources: Federation of European Employees, Bureau of Labor Statistics union shop arrangement under which workers must join a union after being hired modified union shop arrangement under which workers have the option to join a union after being hired agency shop arrangement under which nonunion workers must pay union dues civilian labor force noninstitutionalized part of the population, aged 16 and over, either working or looking for a job Because most firms in the United States today are directly or indirectly engaged in interstate commerce, few, if any, closed shops exist. The second union arrangement is the union shop, where workers do not have to belong to the union to be hired, but must join soon after and remain a member for as long as they keep their jobs. Another union arrangement is the modified union shop. Under this arrangement, workers do not have to belong to a union to be hired and cannot be made to join one to keep their jobs. If workers voluntarily join the union, however, they must remain members for as long as they hold their jobs. Finally, agency shop is an agreement that does not require a worker to join a union as a condition to get or keep a job. It does require the worker to pay union dues to help pay for collective bargaining costs. Nonunion workers also are subject to the contract terms negotiated by the union, whether or not they agree with the terms. An agency shop is also known as “fair share.” Unions like to use this term to remind everyone that the dues the non- members pay to the union are used on behalf of all the workers, whether they are union members or not. Unionized Workers in the Labor Force Today, the United States has a population of about 300 million people. Approximately half of the people belong to the civilian labor force—men and women 16 years old and over who are either working or actively looking for a job. The civilian classification excludes the prison population, other institutionalized persons, and members of the armed forces. Approximately 12.5 percent of working Americans are union members. An additional 1.2 percent of working people are represented by unions in the form of the agency shop discussed above. Union membership is uneven among the different demographic groups in the United States. Men are more likely than women to be union members, although the gap has narrowed considerably in the last 20 years. Older workers, especially those over the age of 45, are more likely to be organized 204 UNIT 3 Economic Institutions and Issues than younger workers.
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African Americans are more likely than others to belong to unions, while Asian Americans and Hispanic Americans are least likely to join. Finally, the rate of union memberships among full-time workers is more than twice as high as the rate for part-time workers. Union membership also differs considerably by state. Five states—Alaska, Hawaii, Michigan, New Jersey, and New York—all have union membership rates above 20 percent, which means that one in five workers is unionized. Five other states— Arkansas, North Carolina, South Carolina, Virginia, and Utah—all have membership rates of less than five percent. As shown in Figure 8.3, local, state, and federal governments have the highest rate of unionization. In fact, the rate of union membership in all levels of government is nearly three times that of workers in manufacturing. The food services industry, where most teenagers work, is the least likely to be unionized. Reading Check Contrasting How do the types of union arrangements differ? Figure 8.3 Union Membership and Representation by Industry Industry Local government State government Federal government Utilities Transportation and warehousing Telecommunications Motion pictures and sound recording Construction Manufacturing Education and health services Mining Retail trade Agriculture and related Finance and insurance Food services and drinking places Source: Bureau of Labor Statistics, 2006 Percentage of employed workers who are: Members of unions Represented by unions 41.9 31.3 27.8 27.4 23.4 21.4 15.0 13.1 13.0 8.3 8.0 5.2 2.7 1.6 1.3 45.8 35.0 33.1 28.6 24.4 22.6 15.5 13.8 13.7 9.4 9.5 5.8 3.0 2.1 1.5 Labor unions are most influential in the service industries, which include government, communications, public utilities, and transportation. Economic Analysis Which industries have few union members? SECTION 1 Review Vocabulary 1. Explain the significance of craft union, trade union, industrial union, strike, picket, boycott, lockout, company union, Great Depression, right-to-work law, independent union, closed shop, union shop, modified union shop, agency shop, and civilian labor force. Main Ideas 2. Stating What is the purpose of labor unions? 3. Explaining Why did the AFL-CIO break up? 4. Describing Use a graphic organizer like the one below to describe the different types of union arrangements. Labor Arrangements Critical
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Thinking 5. The BIG Idea How do the major legislative acts discussed in the section reflect the rise and decline of the labor movement? 6. Making Inferences Why has union support in the United States gone through cycles of resistance and strong support? Write a short essay explaining your opinion. 7. Comparing and Contrasting Which of the four kinds of union arrangements would you prefer, and why? 8. Analyzing Visuals Look at Figure 8.2 on page 202. What does the pattern of right-to-work and non–rightto-work states imply about the strength of labor unions? Applying Economics 9. Civilian Labor Force How would joining the armed services affect your participation in the civilian labor force? CHAPTER 8 Employment, Labor, and Wages 205 Profiles in Economics LABOR LEADER To Chávez and the farm workers he represented, La Causa (The Cause) was about something much bigger than themselves. According to Chávez, “The consumer boycott is... a gate of hope through which [farm workers] expect to find the sunlight of a better life for themselves and their families.” César Chávez (1927–1993) • led the only successful union to organize farmworkers • posthumously awarded the Presidential Medal of Freedom in 1994, the highest honor given to civilians ¡Sí, se puede! César Chávez was born in Yuma, Arizona. Like that of many farmworkers, his life was grueling and impoverished. As a boy, he and his family worked all day in the fields picking fruits or vegetables. They moved from place to place throughout the year, forcing César to drop out of school in eighth grade. Farmworkers who tried to organize for safer working conditions, better pay, and benefits were often harassed by farm owners and police. Some were even sprayed with agricultural poisons. With farms spread so far apart, it was difficult to organize strikes by migrant workers. But Chávez believed “it can be done.” Chávez joined the Community Service Organization (CSO) and began helping people with everyday tax, immigration, and education concerns. In 1962 he set up the National Farm Workers Association (NFWA). For three years, Chávez traveled all over California, discussing problems and goals with farm workers. The Grape Boycott When the Agricultural Workers Organizing Committee (AWOC), another farmworkers group, orchestrated a strike against the Delano table grape growers in 1965
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, Chávez and the NFWA decided to join their efforts. A year later, the two groups became the United Farm Workers (UFW). Chávez mobilized thousands of churches and student activists across the country to boycott grapes. At the peak of the boycott, table grape shipments were down by 24 percent in the top 10 North American markets, and more than 14 million people had participated. The boycott’s astounding success led to historic contracts between the UFW and the Delano growers in 1969. Chávez and his team had won union recognition, higher wages, a health plan, and other concessions. Yet for all of his labor struggles for others, Chávez never made more than $5,000 a year. Examining the Profile 1. Summarizing How did Chávez initially try to approach farmworkers? 2. Applying Information How would a successful boycott impact the demand for grapes? 206 UNIT 3 Economic Institutions and Issues Arthur Schatz/Time Life Pictures/Getty Images SECTION 2 Wages and Labor Disputes GUIDE TO READING Section Preview In this section, you will learn that unions and management negotiate contracts through a process known as collective bargaining. Academic Vocabulary • anticipate (p. 211) • distorted (p. 212) Content Vocabulary • wage rate (p. 208) • unskilled labor (p. 208) • semiskilled labor (p. 208) • skilled labor (p. 208) • professional labor (p. 208) • market theory of wage determination (p. 209) • equilibrium wage rate (p. 209) • theory of negotiated wages (p. 210) • seniority (p. 210) • signaling theory (p. 210) • collective bargaining (p. 211) • grievance procedure (p. 211) • mediation (p. 212) • arbitration (p. 212) • binding arbitration (p. 212) • fact-finding (p. 212) • injunction (p. 212) • seizure (p. 212) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below that describes the different ways labor disputes are resolved. Resolution ISSUES IN THE NEWS NHL Shakes Off Lockout, Long Layoff —National Public Radio [The] NHL owners took a very hard line with the Player’s Association and in the end the players accepted a big salary cut and a per team salary cap. Now the NHL has reduced its spending on players’ salaries to about 54 percent
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of revenue, down from about 75 percent. [The NHL] says it’s going to save up to 400 million dollars. Twice as many teams are going to be in the black. Fans are returning to the rinks, but there’s still some operating issues for teams in smaller markets. They’re sort of facing a choice, do we lose five or $10 million or do we spend up to the salary cap and compete? ■ Over the years, many disputes have occurred between labor and management. Sometimes employees take action against their employer, as during the 2005 transit worker strike in New York City that shut down buses and subways. Sometimes the employer takes action against its employees, as during the 2004 National Hockey League (NHL) player lockout that cancelled the professional hockey season for a full year. Most labor disputes occur over pay and working conditions. If a dispute results in an actual work stoppage, both sides stand to lose enormous sums of money. As a result, and regardless of the reason for the dispute, the deliberations to end it are usually intense. While the NHL was finally able to settle its labor dispute through negotiation, there are other ways to resolve a deadlock. Getty Images CHAPTER 8 Employment, Labor, and Wages 207 wage rate prevailing pay scale for work performed in an occupation unskilled labor workers not trained to operate specialized machines and equipment semiskilled labor workers who operate machines that require a minimum amount of training skilled labor workers who are trained to operate complex equipment and require little supervision professional labor workers with a high level of training, education, and managerial skills Skills Handbook See page R53 to learn about Comparing Data. Wage Determination MAIN Idea Different occupations and levels of training are rewarded with different wages. Economics & You When you choose an occupation, do you want to earn as much income as possible? Read on to learn how your choices can result in a higher wage. Most occupations have a wage rate, a standard amount of pay given for work performed. Wage rates usually differ from one occupation to the next, and sometimes even within the same occupation. There are four explanations as to why this happens. Noncompeting Categories of Labor One explanation recognizes four broad categories of labor that have different levels of knowledge and skills. The highest pay goes to people in jobs that require the most skills and training. Because workers in one category do not compete with those in other categories, wages differ. The first category is unskilled labor and consists of workers in jobs that do not require people with special
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training and skills. People in these jobs work primarily with their hands at tasks such as picking fruit or mopping floors. The second category comprises semiskilled labor—workers in jobs that require enough mechanical skills to operate machines for which they need a minimum amount of training. These workers may operate basic equipment such as electric floor polishers, cleaning equipment, lawnmowers, and other machines that call for a modest amount of training. The third category is skilled labor and consists of workers who operate complex equipment and perform most of their tasks with little supervision. These workers have a higher investment in education, knowledge, and training. Examples include carpenters, electricians, tool and die makers, computer technicians, and computer programmers. The final category is professional labor, or those individuals that have the highest level of knowledge-based education and managerial skills. Examples include teachers, doctors, scientists, lawyers, and top managers such as corporate executives. If you examine the occupations shown in Figure 8.4, you will see that the income each occupation earns is closely associated with these four categories of labor. For example, semiskilled workers, such as transportation and material movers, generally receive more than unskilled workers in the food-service occupations. Likewise, the professional workers in legal and managerial occupations earn more than any of the other occupations in the figure. Figure 8.4 Median Weekly Earnings by Occupation and Union Affiliation Weekly earnings are significantly higher for workers in highly skilled occupations or with union representation. Economic Analysis Why is the earnings gap between union and nonunion workers smaller in managerial occupations than in other occupations? Occupation Represented by unions Nonunion workers Legal occupations Management occupations Computer and mathematical Education, training, and library Protective service occupations Transportation and material moving Office and administrative support Sales and related occupations Building and grounds, cleaning, maintenance Food preparation and serving related Source: Bureau of Labor Statistics, 2006 $1,147 1,137 1,009 913 896 721 689 623 528 439 $1,042 1,076 1,141 710 568 508 528 622 378 350 Figure 8.5 Market Theory of Wage Determination The market theory of wage determination explains how the market forces of supply and demand determine the equilibrium wage rate. Panel A shows what happens when a relatively large supply of roofers is coupled with a relatively low level of demand. Panel B shows what happens when a relatively small supply of professional athletes is paired with a relatively high level of demand. Economic Analysis How does
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this theory differ from the theory of negotiated wages? See StudentWorks™ Plus or glencoe.com. A R OOFER B P ROFESSIONAL A THLETES Low demand and high supply result in low annual wages. $18,000 D $1,000,000 High demand and low supply result in high annual wages. D 0 Quantity 0 Quantity Market Theory of Wage Determination Another explanation for the differences in pay many people receive is based on the market theory of wage determination. This theory states that the supply and demand for a worker’s skills and services determine the wage or salary. For example, if there is a low demand for roofers but a relatively large supply, the result would be relatively low wages for roofers. If conditions are reversed, so that the demand is high and supply is low, then wages would be much higher. This describes the market for the services of professional athletes. In this market, a small supply of talent combined with relatively high demand results in higher wages. You can see this interaction of supply and demand in Figure 8.5. In each market, the intersection of supply and demand determines the equilibrium wage rate— the wage rate that leaves neither a surplus nor a shortage in the labor market. Exceptions to the market theory may appear to exist at certain times. Some unproductive workers may receive high wages because of family ties or political influence. Highly skilled workers may receive low wages because of discrimination based on their race or gender. market theory of wage determination explanation of wage rates relying on theory of supply and demand equilibrium wage rate wage rate leaving neither a surplus nor a shortage in the market Million-Dollar Paychecks The pay for top CEOs reflects the high demand for the best business leaders in the nation. Their base salary actually may not be all that high. Yet CEOs usually pocket a variety of extras, such as retirement benefits, bonuses, stock options, and—for some—tax reimbursements. Add all this together, and total compensation can easily reach into the millions of dollars. CHAPTER 8 Employment, Labor, and Wages 209 Signaling Theory The fourth explanation for differences in wage rates is based on signaling theory. This theory states that employers are willing to pay more to people with certificates, degrees, and other indicators that “signal” superior knowledge or ability. For example, a sales firm might prefer to hire a college graduate with a major in history than a high school graduate who excelled in business courses. While this may seem odd, some firms view the
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degree as a signal that the individual possesses the intelligence, perseverance, and maturity to succeed. You might hear from friends that they did not need their college degree to do the job they currently have—as if their education was not important. They overlook the signaling theory, which helps explain why they got the job in the first place. Reading Check Explaining What is the difference between the market theory of wage determination and the theory of negotiated wages? Theory of Negotiated Wages Unions sometimes threaten with a boycott to get wage concessions. What factor is necessary for effective bargaining? Signaling Theory People who enter the workforce with a college degree can expect higher pay. What signal does a degree send to a potential employer? theory of negotiated wages explanation of wage rates based on the bargaining strength of organized labor seniority length of time a person has been on a job signaling theory theory that employers are willing to pay more for people with certificates, diplomas, and other indicators of superior ability Personal Finance Handbook See pages R16—R19 for more information on education. Theory of Negotiated Wages The third approach to wage rate determination recognizes the power of unions. The theory of negotiated wages states that the bargaining strength of organized labor is a factor that helps to determine wages. A strong union, for example, may have the power to force higher wages on some firms because the firms would not be able to afford work interruptions in case of a threatened strike. Figure 8.4 on page 208 helps validate the theory of negotiated wages. With only one exception, the figure shows that workers who are represented by unions receive weekly salaries that are higher than those of nonunion workers. One important factor for unions is seniority— the length of time a person has been on the job. Because of their seniority, some workers receive higher wages than others who perform similar tasks, even if they do not have better skills. 210 UNIT 3 Economic Institutions and Issues (l) Art Vandalay/Getty Images, (r) David H. Wells/Corbis Resolving Labor Disputes MAIN Idea There are a number of different ways to resolve a labor dispute if collective bargaining fails. Economics & You Have you ever bargained with someone to get something you wanted? Read on to find out how unions do the same thing to get the wages and benefits they want for their workers. When organized labor negotiates with management, disputes are bound to happen. Both sides can use collective bargaining to minimize such disputes. If this fails, they can turn to mediation,
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arbitration, fact-finding, injunction and seizure or, in extreme cases, presidential intervention. Collective Bargaining Labor-management relations usually require collective bargaining—negotiations that take place between labor and management over issues such as pay, working CAREERS Labor Relations Specialist collective bargaining process of negotiation between union and management representatives over pay, benefits, and job-related matters grievance procedure provision in a labor contract that outlines how future disputes and disagreements will be resolved hours, health care coverage, and other jobrelated matters. During collective bargaining, elected union officials represent workers, and company officials in charge of labor relations represent management. Collective bargaining requires compromise from both parties, and the discussions over issues may go on for months. If the negotiations are successful, both parties agree on basic issues such as pay, working conditions, and benefits. Because it is difficult to anticipate future problems, a grievance procedure—a provision for resolving issues that may come up later— may also be included in the final contract. Normally, union and management are able to reach an agreement because the costs of failure are so high. Workers, for example, still have to make regular payments on car loans and mortgages, and companies don’t want to lose customers to other businesses. In short, everyone has a big stake in resolving labor issues. The Work * Formulate labor policy, oversee industrial labor relations, and negotiate collective bargaining agreements * Coordinate grievance procedures between unions, workers, and management * Handle complaints that result from contract disputes Qualifications * Knowledge of fair wages and salaries, benefits, pensions, labor law, collective bargaining trends, and union and management practices * Ability to be patient, fair- minded, and persuasive, and to function under pressure * College courses in labor law, collective bargaining, labor economics, labor history, and industrial psychology * Many positions require graduate studies in industrial or labor relations Earnings * Median annual earnings: $93,895 Job Growth Outlook * Faster than average Source: Occupational Outlook Handbook, 2006–2007 Edition Comstock Premium/Alamy CHAPTER 8 Employment, Labor, and Wages 211. Arbitration is finding its way into areas beyond labor-management relations. Today, for example, most credit card companies require disputes with cardholders to be solved by an arbitrator rather than in the courts. This means that a credit card holder can no longer sue the credit card company in the event of a dispute because the matter goes to arbitration instead. “A good negotiator can stand back and gain perspective.” Mediation Mediators need
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